Perrigo: A Solid Consumer Goods Business With VC-Like Optionality

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About: Perrigo Company (PRGO)
by: The Belgian Dentist
Summary

Perrigo has both in the US and Europe a solid, cash-flow generating, consumer-oriented, healthcare business.

The new CEO Murray Kessler is the right man in the right place.

Current valuation assumes Perrigo will lose both its big litigation cases.

2018 was a horrible year for Perrigo (PRGO) and its shareholders. Profit-warning after profit-warning and at the end, as icing on the cake, the heavy tax claim in Ireland. In 2018, Perrigo had three CEOs. It decided to sell or spin off its generics business, but the outlook for this business worsened and this caused Perrigo to lower twice its earnings guidance and will have a negative effect on the selling price for this division. The two remaining divisions, Consumer Healthcare Americas and Consumer Healthcare International, will be the healthy base of the new Perrigo.

2018: an annus horribilis

In January, Uwe Roehrhoff was appointed president and CEO to replace John Hendrickson.

At the presentation of the second-quarter results, Perrigo lowered its guidance for calendar year 2018 adjusted diluted EPS from a range of $5.05 to $5.45 to a range of $4.75 to $4.95. The profit-warning was primarily due to revised expectations for the generics RX segment.

In October, Perrigo announced Murray Kessler, a former tobacco industry executive, would become the company’s third chief executive officer that year.

At the publication of the third-quarter results in November, Perrigo lowered again its full-year guidance, as it now saw EPS between $4.45 and $4.65, down from $4.75 to $4.95, on revenue of $4.72 billion, down from $4.8 billion to $4.9 billion. Consensus called for EPS of $4.86 on revenue of $4.87 billion. Again, 2018 guidance was lowered primarily due to the generic prescription segment.

In December Perrigo received a €1.6 billion ($1.8 billion) bill from Irish tax authorities, related to its 2013 takeover of Elan.

As a result, Perrigo was one of the worst-performing companies in the S&P last year. Only 4 stocks performed worse.

Exhibit 1: Worst S&P 500 performers

Generic woes

Both Perrigo’s profit-warnings in 2018 were caused by disappointing results in its generic division. Perrigo decided in 2018 that it would separate this generic-drugs business, Rx pharmaceuticals, and focus on consumer healthcare. Perrigo hopes jettisoning its generic-drug business, either via spinoff, sale or merger, will stabilize the company.

In August last year, Perrigo’s board had OK’d a plan to split off the company’s prescription drugs business. It’s a move Perrigo’s directors think will allow the company to “focus on expanding its leading consumer business,” and all options are on the table, including a “tax-efficient separation to shareholders,” a sale or a merger.

The generics business faces some strong headwinds. Regulators attempt to encourage competition which will lead to lower prices.

Another threat is the emergence of a large non-profit competitor. Last year a consortium of hospitals announced it has chosen the name Civica Rx for its nonprofit venture to produce generic drugs. It also said Martin VanTrieste, former chief quality officer for Amgen (NASDAQ:AMGN), has been appointed chief executive. More than 120 health organizations, representing about a third of the nation’s hospitals have expressed a commitment or interest in participating, according to Civica. “We are creating a public asset with a mission to ensure that essential generic medications are accessible and affordable,” said VanTrieste. “The fact that a third of the country’s hospitals have either expressed interest or committed to participate with Civica Rx shows a great need for this initiative. This will improve the situation for patients by bringing much-needed competition to the generic drug market.” Civica Rx expects to have its first products on the market as early as 2019.

Research into the actual costs of manufacturing and distributing generic drugs suggests that, in many instances, prices for generic drugs used in hospitals can be reduced to a fraction of their current costs. This can save patients, and the healthcare systems that care for them, hundreds of millions of dollars each year.

This is good news for patients, but less so for manufacturers of generic drugs like Perrigo’s Rx pharmaceuticals.

The separation of the generics prescription business was expected to be completed in the second half of 2019. But the tax dispute could influence the type and timing of the transaction.

Last year Novartis (NYSE:NVS) sold its generics division Sandoz for less than one-time sales. It remains to be seen how much Perrigo will fetch for its generics division (which has $800 million in sales).

New CEO

As it transitions away from prescription drugs toward over-the-counter pharmaceuticals and other health products, Perrigo appointed Murray Kessler, a former tobacco industry executive, to become its new CEO.

Kessler, 59, is the former CEO of Lorillard Tobacco. He replaces Uwe Roehrhoff, who was appointed president and CEO in January 2018 to replace John Hendrickson.

Many medical journals, healthcare charities, healthcare regulators and drug firms have strict rules or informal bans on having anything to do with the tobacco industry. The appointment of Kessler proves that Perrigo sees itself no longer as a pharmaceutical company but as a consumer goods company, certainly after it will get rid of its generic drugs division.

Kessler has spent nearly three decades in consumer packaged goods business and has worked with Campbell Soup (CPB) and Clorox (CLX). He was most recently the chief executive officer and president at Lorillard Tobacco. Lorillard’s market value surged to about $28 billion from about $9 billion during Kessler’s tenure as CEO between 2010 and 2015.

Quality company

The generics division may have caused two profit-warnings in 2018, but Perrigo remains a healthy, free-cash-flow generating, quality company.

The Piotroski-score for Perrigo stands at 8. The Piotroski-score is a financial score between 0-9 which reflects nine criteria used to determine the strength of a firm's financial position. This Score helps to identify the best value stocks. Scores 7-9 are the best and 0-3 are the worst.

Despite the two profit-warnings, Perrigo isn’t trying to “cook its books.”

A well-known way to check if a company has been manipulating its earnings is the so-called Beneish M-score.

The zones of discrimination for the M-Score is as such:

  • An M-Score of less than -1.78 suggests that the company is not an accounting manipulator.
  • An M-Score of greater than -1.78 signals that the company is likely an accounting manipulator.

The Beneish M-score for Perrigo was -2.61 at the end of the third quarter and remains firmly below -1.78.

Tax dispute

Perrigo received a €1.6 billion ($1.8 billion) bill from Irish tax authorities, related to its 2013 takeover of Elan. By the way, that figure doesn’t include interest or penalties. At the heart of the problem is Elan’s sale of the multiple sclerosis treatment Tysabri to Biogen (BIIB), as Ireland says that the upfront payments for the drug should have been taxed at a higher rate. Although Perrigo said in a regulatory filing that it plans to appeal in a filing and that it paid the correct tax rate, it admits that it could take years before a legal resolution is made. Perrigo treated payments from the asset sale as trading income, which is taxed at 12.5 per cent. Irish authorities say it should be treated as “chargeable gains” and taxed at 33 per cent.

The day the news came out, Perrigo’s share price fell almost 30% from $52.36 to $37.03. Perrigo’s market cap dropped $2.1 billion, from $7.15 to $5.05 billion!

Second dispute

The tax issue isn’t the only judicial case for Perrigo.

Perrigo acquired Belgian OTC-company Omega Pharma on March 30, 2015, in a cash and shares transaction worth around €3.8 billion ($4.3 billion) including the assumption of €1.3 billion ($1.5 billion) in debt.

Perrigo purchased Omega from Marc Coucke – Omega's founder and chief executive officer – Waterland Private Equity Fund and co-investors of Waterland. Coucke joined Perrigo as part of the deal.

In April 2016, Perrigo announced that Coucke had resigned from the company. Around the same time, Perrigo said it was assessing a "possible impairment" involving the Branded Consumer Healthcare business. Later Perrigo filed an "arbitral claim" against the sellers of Omega Pharma.

Perrigo requires no less than €1.9 billion ($2.1 billion) of Marc Coucke and fund Waterland on account of alleged fraud in the sale.

Perrigo accuses Coucke and Waterland of fraud. A panel of arbitrators should decide whether it is effectively the case.

A decision of the panel of arbitrators cannot be appealed. Because of the size and the complexity of the matter, no decision is expected until 2021.

VC-like optionality

Value investing and venture capital investing are not the only ways to invest, but they share many elements like fundamental analysis, circle of competence, rationality, a margin of safety and most importantly a search for a mispriced asset.

In venture capital, the mispricing occurs because very few investors or asset owners understand optionality. This allows a VC to buy what are essentially long-dated, deeply-out-of-the-money call options from companies at prices which are a bargain.

Wise VCs engage in tinkering in domains which tend to produce a small downside and potentially massive upside.

And Perrigo fits that bill. The downside is limited thanks to the solid consumer healthcare business and the two litigation cases offer the potential for a big upside.

Expectations are low

Nevertheless, the expectations are low. No analyst has a buy recommendation and the big majority of the analysts following the company have a hold rating on Perrigo.

Exhibit 2: Analyst expectations

Valuation and price target

After the bad performance in 2018 and the lowered earnings guidance, Perrigo is trading at a P/E of only 10.

Our DCF-based target price is $58. This implies a P/E of almost 13 and an EV/EBITDA of almost 13. For completeness sake, this target price assumes Perrigo will have to pay the Irish tax claim and receives no money from the arbitration case against the sellers of Omega Pharma.

Conclusion

In spring Perrigo will host an analyst day where it will give 2019 guidance. In the meantime, we do not exclude that the Q4 results would disappoint (cfr. Teva’s soft 2019 guidance) and/or the price Perrigo fetches for its generics division is lower than expected. Any price weakness caused by these concerns could prove a good buy-moment for this solid business with VC-like optionality linked to the two big litigation cases.

This article provides opinions and information, but does not contain recommendations or personal investment advice to any specific person for any particular purpose. The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.