Lannett Company: Any Hope Left?

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About: Lannett Company, Inc (LCI)
by: The Insiders Forum

Summary

Generic drug maker Lannett Company has seen its stock crater from north of $70 in 2015 to under $4 now.

A bad acquisition, pricing headwinds in the sector, and the recent loss of its biggest customer are chiefly responsible for the decline.

Insider buying and some rarely seen valuation metrics merit further examination of this out of favor company.

Our investment analysis of this market 'pariah' is presented in the paragraphs below.

Memory is more indelible than ink." - Anita Loos

Few stocks have destroyed more shareholder value in recent years than Lannett Company (LCI). The stock lost another 20% of its value in trading Monday after announcing a $340 million write-off for goodwill and that has engaged advisors to assist it in evaluating its options related to its debt and capital structure. Will the stock ever quit being a 'falling knife'? Based on some recent insider buying, some members of the company seem to believe so. We examine this stock market pariah in the paragraphs below.

Company Overview:

Founded in 1942, Lannett Company is a Philadelphia-based developer, manufacturer, marketer, and distributor of generic pharmaceuticals for a broad spectrum of indications. The company has seen its top-line grow from $12.1 million in fiscal year (FY) 2001 to $684.6 million in FY18, a result of FDA approvals for its generic drugs, distribution of other pharmaceutical companies' generics, and acquisitions. Despite its growth, its stock has plummeted ~80% in the past nine months, the most recent setback - a ~60% one-day drop on August 20, 2018 - resulting from the loss of its largest customer. This now ~$150 million concern operates on a fiscal year ending June 30th.

The trouble for Lannett began in late 2015 when it purchased Kremers Urban Pharmaceuticals for ~$1.2 billion. Just prior to the deal closing, Kremers announced that it had lost an $87 million customer or about 20% of its prior year sales. Despite this news, Lannett loaded up with debt and completed the acquisition - much to the demise of its shareholders - believing (incorrectly) that it could find additional cost savings and obtain new customers to replace the revenue from the departing one. Lannett's stock, which traded north of $70 prior to the deal closing, started a protracted decline that has yet to abate, and trades just around $3.75 a share.

Deja Vu:

The most recent iteration of bad news occurred on August 20, 2018, when Lannett announced that its exclusive distribution agreement with privately-held Jerome Stevens Pharmaceuticals (JSP) - a contract dating back to 2004 - would not be renewed but would instead expire on March 23, 2019. This was a huge blow to Lannett, as its revenue from the sale of JSP products - mainly Levothyroxine Sodium Tablets USP (Levo) - totaled $253.1 million in FY18 or 37% of total net sales. Equally crushing was the ~60% gross margins derived from these sales versus ~40% from the rest of its portfolio.

To offset the future loss of Levo and other JSP products, Lannett intends to accelerate new product launches and find additional strategic partnerships. To that end, the company has launched eight products since January 2018 that should contribute $50 million to its top-line in FY19. In February 2018, the company acquired five products from UCB (Euronext: UCB) for $5 million and in May 2018, purchased over 20 products from a subsidiary of Endo International plc (ENDP) for an upfront payment of $12 million and future milestone considerations. With its current pipeline, management intends to maintain a launch cadence of at least one new product a month for some time into the future. In total, its portfolio of approved but not yet launched products will be introduced into end markets totaling more than $2 billion. Additionally, Lannett has already filed five new ANDAs covering two product families with an expectation of at least five more in FY19. All in, products from owned or partner sources that are currently pending approval from the FDA have a combined IMS value north of $4 billion. Keep in mind, the values of these markets are likely to decrease due to the introduction of generics and their resultant pressure on pricing.

On the expense side, the company is examining ways to reduce its cost of sales, R&D, and SG&A while cutting capex. So far, Lannett has restructured its Cody Laboratories' active pharmaceutical ingredient business to reduce operating overhead by ~$10 million annually. Additionally, the company's Seymour, Indiana facility has recently increased its output by ~50% to 3.9 billion doses and assumed distribution functions previously handled in Philadelphia. Lannett also sold two unused buildings in Philadelphia for $14 million in July 2018.

In addition to finding new sources of revenue and opportunities to operate more efficiently, Lannett will look to restructure its substantial ($893.5 million) debt - mostly a function of the Kremers acquisition - which was downgraded by both Moody's (to B3) and S&P (to B-) on the back of the JSP news. Specifically, management will likely look to refinance a significant portion of its outstanding long-term debt to reduce principal repayment requirements and eliminate existing financial covenants, which will probably increase related interest expense but will positively impact cash flows. Currently, the majority of the debt is due in FY21 (~$218.5 million) and FY23 (~$522.5 million).

FY18 Results and FY19 Guidance:

The JSP news cast a huge pall over what were essentially in-line, albeit slower growth results. FY18 net sales of $684.6 million were up ~7% over FY17. Non-GAAP net income for FY18 was $3.10 per share versus $2.86 in FY17. Gross profit was $326.2 million, or 48% of adjusted net sales compared with $343.7 million, or 54% of adjusted net sales in FY17. The decrease in gross profit margin was mostly attributable to the dilutive impact of Kremers' products - the gift that keeps on giving - sales mix, and changes within distribution channels. R&D expenses decreased to $29.2 million from $42.1 million in the prior fiscal year. SG&A expenses were $71.0 million compared with $71.3 million. Operating income was $226.0 million compared with $230.3 million for the prior year.

Of course, the story with Lannett is its uncertain future, not its past year's results. To that end, management guided the Street to a revenue range midpoint of $595 million for FY19, but one must keep in mind that ~$150 million of high margin business will still be derived from the expiring JSP deal, which is expected to generate ~$50 million per quarter through 3QFY19. Gross margins for FY19 are expected to decline to 44%-45%; R&D expenses should remain relatively flat at ~$30 million, and SG&A are expected to decrease ~10% to ~$64.5 million - in keeping with management's cost-cutting initiatives to offset the loss of JSP. The company did not provide specific non-GAAP earnings guidance for FY19 but from extrapolation, it looks to be slightly north of $2 per share.

Balance Sheet & Analyst Commentary:

Lannett's balance sheet showed $98.6 million in cash and $839.3 million of debt on June 30th, 2018. The cash line does not reflect the $14 million received from the sale of the two buildings in Philadelphia. The company also has an undrawn $125 million revolving credit facility. It should be noted that one of Lannett's term loans is subject to a financial performance covenant, which provides that Lannett can't permit its secured net leverage ratio as of the last day of any four consecutive fiscal quarters to be greater than 3.75 to 1. That should not be a concern until after the JSP deal officially expires.

Based on this picture, the Street is predictably a sea of negativity regarding Lannett's prospects. Raymond James, Craig Hallum, and Roth Capital each downgraded the stock on the JSP news, leaving all seven analysts who have made commentary about the company in the past year with hold ratings. Twelve-month price targets have not all been adjusted to reflect the news but for the ones who have, the range is $7-$8 per share.

Despite analyst pessimism, CEO Tim Crew and board member Patrick Lepore both purchased shares after the JSP news in the $5s. It should be noted that they both purchased shares in May 2018 when the stock was ~$10 higher as well. In addition, the duo purchased just under $150,000 in total of the stock with their recent purchases. A nice vote of confidence but hardly 'backing up the truck' money.

Verdict:

It is rare one will ever see a stock trading at less than 2x's trailing twelve-month (non-GAAP) earnings or less than 3x's next twelve months' non-GAAP earnings. There are obvious reasons for these dynamics. Although this is not the way the company wanted to get there, with the loss of its largest customer, it is no longer exposed to one customer. This perverse logic means that with the loss of Levo, Lannett's top five drugs going forward will account for less than 40% of its revenues versus ~58% in FY18, leaving it less exposed to this scenario in the future. Removing JSP revenues, the stock is currently trading at .4x's FY18 revenues and FY19 forecasted revenues.

Pricing pressures throughout the industry and Lannett's significant debt load are concerns especially given the recent news about engaging advisors to address its capital structure, as are the replacement of high margin products with lower ones. However, the selloff could be significantly overdone, especially if the company's debt can be restructured.

This name is way too risky to be a significant holding in any weight. However, those comfortable with significant risk, this potential turnaround situation might warrant a small bet within a well-diversified portfolio. That is my plan for my own personal portfolio within a buy-write option order.

It is strange how we hold on to the pieces of the past while we wait for our futures." - Ally Condie, Matched

Bret Jensen is the founder and author of articles on The Biotech Forum, The Busted IPO Forum, and The Insiders Forum. To receive these articles as published on Seeking Alpha just click the appropriate link and hit the orange follow button.

Disclosure: I am/we are long LCI.

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.