Endo Pharmaceuticals Should Survive Up To $3 Billion Worth Of Opioid Litigation, Making Shares Undervalued

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About: Endo International plc (ENDP)
by: Zhiyuan Sun
Summary

Endo is a well managed, organic R&D company returning to growth despite looming litigation risks on the horizon.

Its branded drugs and sterile injectable portfolios are rich in value, with label expansions for the treatment of cellulite a candidate for blockbuster drug status.

The company's products have so much potential that even $3 billion worth of opioid settlements shouldn't deliver a killing blow to bankruptcy.

Introduction

Endo Pharmaceuticals (ENDP) is a specialty-generic company focused on producing branded drugs, sterile injectables, opioid pain killers, and generic competitors to off-patent chemical entities. Despite generating organic growth with its products and pumping out quality R&D, ENDP can find no escape from the brewing Opioid Crisis with its 20% share of the opiate painkiller market. At least 200,000 Americans have been killed since 2010 by a combination of unethical marketing; over prescriptions; fentanyl smugglers, and black market opiates. Whether or not ENDP is guilty is really not the concern anymore, as the public is out for blood with over 2,000 lawsuits to Purdue Pharmaceuticals alone for their role in fraudulent/aggressive marketing tactics. Settlements for such litigation is estimated in the 10 figure ranges, and ENDP is already managing its liquidity for such outcome.

The question then becomes whether or not ENDP can survive such litigation settlement. The new management team has been able to lift the company out of its failed levered acquisition strategy post 2016, and has invested heavily in R&D for organic growth, but will this be enough to steer the ship away from the iceberg?

The author will find it out by first, presenting an overview of the company with its key product and phase 3 CCH clinical trial; second, dissecting all aspects of the company and assign a quantitative score to each category; third, analyzing the impact of opioid litigation in detail; and finally, estimating the company's future cash flows with all assumptions and outcomes in mind. Based on the analysis, the author believes ENDP can survive up to $3 Billion worth of opioid litigation and settlements, and STILL make a decent return for shareholders. Let's take a closer look:

Note 1: ENDP's opioid exposure will be discussed in great detail in the "Legal Risks" section. It will be omitted everywhere else in the article as I feel it is critical to have all the information in one place for this important investment risk.

Note 2: For readers who are savvy about probabilities and expected values, you may find some very worthwhile content at the "Final Grades" Section at the end of the article.

Overview

Source: Company Presentation

Endo's business consists of branded drugs (XIAFLEX, SUPPRELIN), sterile injectables (Vasostrict, ADRENALIN), and generic opiates (Morphine, Hydrocodone) whilst selling all of the products listed above internationally. The company's top selling drugs are XIAFLEX and Vasostrict, achieving over $800 million+ in sales in FY 2018, or 24% of all ENDP's overall revenue.

Vasostrict (Patent expiry in 2035) increases blood pressure in adults with vasodilatory shock who remain hypotensive despite fluids and catecholamines (common amongst patients with diabetes insipidus). VASOSTRICT is currently the first and only vasopressin injection with an NDA approved by the FDA. Sales are ranging close to $500 million in the past fiscal year, and are continuing to grow in the low double digits. This is rather good news as the patent expiry is so, so, far out. ENDP will have exclusive rights to market this drug for a very long time. Let's take a look at their next gem:

XIAFLEX (Patent expiry in 2028) is indicated for the treatment of adult patients with DC with an abnormal buildup of collagen in the fingers. It is also indicated for the treatment of adult men with PD with a collagen plaque and/or penile curvature deformities. Over 125,000 (or just 20-25%) of patients have been treated with the drug since 2010, and its efficacy is quite impressive, beating placebo by close to a 900% margin:

Source: XIAFLEX Website

In addition, ENDP is currently conducting a clinical trial to expand the drug's label to the treatment of cellulite. When approved (and why not "if" will be discussed below), the drug has the potential to achieve blockbuster status due to both 1) Sheer number of patients affected by this syndrome and 2) The lack of any FDA approved treatment for this condition. Let's check it out below:

CCH Trial Analysis (XIAFLEX Label Expansion)

Image result for collagenase clostridium histolyticum

Source: Endo Investor Relations, Author's Curation

Primary Endpoints:

With p values of 0.006 and 0.002, there is little doubt with regards to the efficacy of the drug. So, therefore, the drug must be on a straight path to approval right?

Not so fast...

There are two types of errors in statistics: Type I errors (dealing with p values), involves incorrectly rejecting a true null hypothesis (or false positive). Luckily, these kinds of errors can be resolved using rigorous statistical analysis as ENDP's team has done above.

Type II errors, however (dealing with trial design), involves failing to reject a false null hypothesis (or false negative). In the trial results above, we see the improvement of cellulite post treatment to be 7.6% and 5.6% respectively, versus 1.9% and 0.5% for placebo. While locally, this may represent a statistically significant increase of 300-1000% efficacy vs. placebo, but globally, these data are really not that great (ex., compared to a standard of 50% patient improvement). Is it really reasonable for 1,000 patients to take the drug, but only for 56-76 patients to show improvements?

Therefore a key investment risk is the drug may be required for re-trials before approval. The minimal p-value suggests this drug does indeed work. The FDA, however, may require a new trial with higher dosage (versus 0.84mg/treatment area), or a longer trial period (versus 21 days) and delay its approval well into the mid-2020s.

Secondary Endpoints:

Luckily, the secondary endpoints have a collection of saving graces. First of all, almost every single endpoint was beat with CCH, and the results weren't even close to what placebo accomplished. Endpoints such improvement of cellulite at day 71 were beaten by a huge 2x-3x margin. Secondly, 67-73% of patients were satisfied with the aesthetic outcome of the drug, which compliments the questionable outcome of the primary endpoints.

The Last Secondary Endpoint And What It Means:

There has been much debate on the failure of the last secondary endpoint. To make it clear, this variable is strictly focused on the NON-treatment area after the treatment area has been injected with CCH. What this means is, the investigation was meant to determine the size of the treatment area of the injection over a period of 71 days and has nothing to do with the drug's efficacy. The main concern remains with the global questionable efficacy of the drug.

Safety:

Not a single serious adverse event was reported in a trial of n=845. Great news, not much else to say here.

Ratings

Products: A- (Again, Opioids will be covered in "Legal Risks")

Both branded drugs and sterile injectables are showing rather impressive growth with patent protection extending to north and south of 2030. Looking at the company's generic business, however, sheds a bit of light on these achievements:

Source: Bloomberg Intelligence

Source: Bloomberg Intelligence

ENDP's legacy generic business is, well, not really "legacy" as it accounts for more than $1 billion in sales in FY2018 or 33% of its overall portfolio. The generic drug price deflation issues are definitely not going away due to unfortunate timing of the U.S. 2020 presidential elections. Public outrage on drug pricing will be a key point of contention for both Republicans and Democrats, and especially with their regards on Medicare reform. Luckily, ENDP has a few opportunities for organic growth:

Source: Bloomberg Intelligence

It is advised to take this chart with a grain of salt. For example, Remodulin from United Therapeutics (UTHR) has gone off-patent in 2018, and ENDP still has yet to file an ANDA for a generic. Products such as Adderall and Concerta though, do possess enough users for generic launches to become lucrative. Overall, expect at least 9 figures in new sales from launch of generics to offset double digit price erosion.

Strength in ENDP's branded and injectable products will be enough to mitigate generics' weakness for some time. This makes the Product Category an A- overall, moving on to IP analysis:

Intellectual Property Protection: A

ENDP's two best selling drugs (Vasostrict and XIAFLEX) account for just south of one quarter of the company's overall sales. Patent rights are owned fully by Endo with far-out expirations of 2035 and 2028 respectively. The company's generic steroid injectables portfolio is doing very well, growing at over +24% Y/Y in FY 2018. Its opioid legacy generic business is not doing well, but that is expected given the crisis at hand and the removal of Opana ER, and the portfolio still generates up to $1 billion in sales. With the recent victory of its exclusivity litigation against the FDA on Vasostrict, this boosts Endo's score from an A- to an A. Being a specialty-generic company instead of just plain generic or plain specialty really gives Endo more flexibility, and the option to have a steady income even after branded products lose patent protections.

Pipeline: A-

Source: Company Presentation

I know, ENDP has nothing in the pipelines other than XIAFLEX label expansion trials; nothing even in the phase 1 or phase 2; nothing in the long term either.

So why is Endo's pipeline deserving of an A-?

Well, what matters here more is quality over quantity. As I have stated before, XIAFLEX has the potential for blockbuster status (>$1 billion in annual peak sales) once approved for its new cellulite label. Over 85-96% of adult women are suffering from this condition with no alternative treatments available. The recent RELEASE 1 and RELEASE 2 have demonstrated very strong clinical efficacy with regards to the drug and did great on all of its secondary endpoints plus safety. The author believes it is only a matter of when, not if, the NDA is approved, as the only concern is the drug being not globally effective, in my opinion, due to Type II errors. Further trials with adjusted trial design (such as greater dosage, greater primary endpoint trial length) are likely to be requested by the FDA. Moving on to management:

Management: A

Source: Company Website

With the new management team steering Endo out of its LBO disaster from 2016; ending its legacy opioid business; and pumping out organic R&D; while simultaneously growing key products like XIAFLEX and Vasostrict by double digits Y/Y, leadership deserves a solid A. Next, let's look at ENDP's business strategy.

Business Strategy: A-

Endo has moved on from its debt infused acquisition strategy led by former CEO Rajiv de Silva back in 2016. Management has been entirely replaced with CEO Paul Campanelli and CFO Blaise Coleman able to keep the ship afloat since that time (and the bonds are doing quite well too trading at over 90 cents on the dollar). The company has seen a return to growth on its sterile injectable and branded drug businesses while reducing risks on its legacy generic business by ceasing spending on opioid developments. Overall, because of ample diversification (being specialty-generic instead of just one of the two) competence of management, and good data coming from its pipelines, the business model deserves an A-. This sums up the positive aspects, now, we are going to take a turn and examine the more darker sides of this company.

Legal Risks: F

Source: Bloomberg Intelligence

The problems start here, brace yourselves...

Using the 1998 Tobacco Master Settlement as a guideline (between companies involved + 46 states), Bloomberg estimates the implied litigation payout to be in range of $1 to $10 Billion for ENDP based on their share of 20% of the opioid pain market. This was a case where tobacco companies were accused of fraudulent and/or unethical sales practices and have direct parallels to companies involved in the current opioid crisis. With the public demanding justice for addiction, crime, death, and costs to taxpayers across America, it is unlikely for Endo to remain unscathed by this wrath. Multiple states are already suing the company for marketing practices regarding pain killer Opana (voluntarily withdrawn from market in late 2017).

Update: After this table was published in 2018, Endo's peer Purdue Pharma recently settled a 3rd opioid lawsuit (out of a staggering 2,000) for $270 million for its a role in a crisis which killed over 200,000 Americans. This is on route to the lower end of the settlement sum forecasted by the table. The author expects the same risk to apply to Endo as well as there are also rumors of aggressive marketing practices on par with Purdue.

There is some light at the end of the tunnel, however, as the company recently received a favorable ruling from the FDA against the unauthorized compounding of Vasostrict. This is the only FDA approved hormone injection to increase blood pressure in adults with vasodilatory shock (such as post-cardiotomy or sepsis), accounting for over 15% of the company's sales in FY2018.

It is satisfying to see a mitigation to Vasostrict's revenue threats, but this is not enough to outweigh potential $10 billion in opioid settlements in the top range. Legal Risks score a clear F grade.

Financial Health: D

Source: Company Presentation

Endo has roughly $8.3 billion in long term debt, with an average interest rate of 6-7%. Combined with $1.45 billion in cash, restricted cash, and securities, this leaves $6.85 billion of net debt. While this is a lot, further keep in mind from the previous section the addition of $10 billion in implied opioid liabilities in the top range. Overall, this yields a whopping $16.85 billion in adjusted Net Debt against just a $1.20 billion FY 2019 adjusted EBITDA guidance. The leverage ratio amounts to a mind-boggling 14x!

But before one hits that "sell short" button in one's brokerage account, however, keep in mind two things:

1) No one knows when the settlement payout will kick in. It could be within 2 years, 5 years, or more than a decade. Heck, it took tobacco companies more than 10+ years to be busted for shady marketing tactics in the 1980s. The further away the payout time, the lesser its value when discounted to the present (via time value of money).

2) The settlement sum is not interest bearing and hence should not simply be bundled with the company's long term debt.

For these reasons, the author assigns a passable grade of D instead of an F for financial health.

Need To Account For Valuation Before Assigning a Final Grade

Great products; management; business strategy; and organic R&D are overshadowed by poor financial health plus a failing grade for potential legal liabilities. This makes the financial analysis a must for any prudent investor wishing to take both long and short positions, see below for greater details.

Future Cash Flow + Opioid Litigation Payout Analysis

Source: Company Presentation

Source: Company Presentation

This guidance, combined with a list of variables analyzed in this article, will be used to give more insight into ENDP's future cash flow streams.

Branded Products: Increase 5-10% Y/Y in sales, XIAFLEX label expansion for cellulite approved much later than market participants expect (due to the need for re-trials), but achieves blockbuster status once released.

Sterile Injectables: Revenues grow by mid 10% every year.

Generics: 9 figure of launches in new products not enough to offset double digit percentage price erosion, decrease by -10% every year.

Adjusted EBITDA Margin: ~40%. The adj. EBITDA margin is used instead of plain EBITDA margin as non-cash expenses from asset impairments are not accounted in the latter metric. For example, over $900+ million in FY2018 of goodwill write downs will be lost without using adjusting this in EBITDA calculations.

Free Cash Flow Margin: 30-50% of adj. EBITDA margin.

Refinance Debt? Yes, Post 2022

Opioid Litigation Settlement: $1 to $10 Billion in one-time, lump sum payment between 2025-2030, no interest accrued before then. The author will assume ENDP's management will set aside "restricted cash" for this settlement every year until fully paid, effectively turning it into a debt instrument discounted at the company's average interest rate of 6-7%.

Let's look at the results:

1. A Reasonable Scenario

Source: Author's Curation

2. Best Case Scenario:

Source: Author's Curation

3.Worst Case Scenario:

Source: Author's Curation

4. Break even Scenario:

Source: Author's Curation

Based on the author's assumption and modeling, the maximum amount of opioid liabilities ENDP can survive is $5 billion, and anywhere between $1 billion of $3 billion will give up to ~50 to 130% return for shareholders. On the other hand, anything over $5 billion would mean certain bankruptcy for the company but not until 2025-2030 or so.

It is important to note the balance of probabilities is not the same across the entire settlement spectrum. That is, the chance of a $1 billion settlement is not the same as a $10 billion settlement. Given ENDP has not been as aggressive as Purdue when it comes to opiates marketing; given the company has voluntarily withdrawn its flagship painkiller drug, Opana ER, and given it is truthfully trying to comply with the FDA in resolving the crisis, the author estimates the probability of a low 10 figure settlement outweighs that of a high 10 figure settlement, and find shares of ENDP to be grossly undervalued. Even with an $8 billion debt stack, factors such as excellent management, product development, and newly reformed business model should keep the ship steering for the next few years, and survive crashing into any opioid litigation icebergs in the low billion dollar range.

Final Grade(s):

Because the value of ENDP's shares will fluctuate significantly based on the payout of implied opioid litigation, the final grading assigned by the author will be based on these outcomes as well. Let's have a look at the following table:

Based on the assumptions throughout this article, and the aid of a fat-tailed distribution of possible settlement scenarios, the author finds the most likely path for ENDP to be 35% chance of a $3 billion payout with a price target of $7.76 and a final grade of B. Likewise, the chances of a score better than B stands at 25%, and the probability of an F stands at 20% combined.

Why Use The Most Likely Outcome Instead of The Expected Value?

Diligent readers may be curious why the author used this method instead of taking the final grade to be the sum of each outcome multiplied by its probability to derive the expected value.

This method has fooled many investors as it is a fundamental misunderstanding of the expected value. Most importantly, the variable assumes the convergence of different outcomes through multiple trials (n>30). Well, for stocks like ENDP, there is only one path (n=1) it will actually take out of all outcomes post analysis. Think of it this way, the only way possible to have the expected value be significant is if one holds a portfolio of at least 30 drug stocks similar to ENDP which are all going through opioid litigation, or investing in ENDP 30 times with an opioid litigation payout on every single one of these investment periods. Both of these scenarios are impossible, and hence, it is much more plausible to use the Most Likely Outcome approach. For these reasons, fearless investors with a stomach for volatility may find ENDP appetizing for their portfolio.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in ENDP over 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.