The Long Case For Taro Pharmaceutical

By Alessandro Villadei :

Target Price and Rationale

Taro Pharmaceutical ( TARO ) is a recommended buy with a price target of $175.

The Company markets over 200 generic pharmaceutical products in over 25 countries and is largely known for its dominating influence in the generic dermatology segment.

Over the last three years, Taro has experienced an ample growth in terms of sales that increased around 42% and significant margins expansion. Taro has concentrated its efforts on reducing costs, eliminating debt, increasing profitability and efficiency, and in committing more capital to research and development.

Taro currently has zero debt but a substantial net cash position of around $1.1 billion.

Cost of sales accounts for less than 18% of revenues, while SG&A expense accounts for less than 10% of revenues. Decreasing COGS, zero debt, and low SG&A expenses significantly reduced the cost structure of Taro enabling the company to sell its products at a discount compared to competitors.

Taro's commitment to delivering new quality products through R&D investments is one of its central priorities; in fact, the company increased its number of products in pre-registration from 27 in 2014 to 36 currently.

Taro's gross margin is 82.15%, while its net profit margin is 56.90%. Free cash flow per share is around $9, and operating margin is around 64%.

By running a fairly conservative DCF valuation, it can be evinced that Taro's current intrinsic value is around $175/share.

Additionally, there are several catalysts likely to happen that will further improve Taro's position in the market.

Relevant Comps

Taro's most direct competitors are: Teva Pharmaceutical ( TEVA ), Akorn ( AKRX ), Merck ( MRK ), and Sandoz (Novartis's ( NVS ) generic subsidiary).

All of the aforementioned companies have a substantially higher cost structure, more debt, and lower margins compared to Taro. However, they are all trading at higher multiples.

Taro's P/E is 10. Its EV/EBIT is 6.8, compared to the peers' mean of 36.3. This indicates that the company is being valued relatively cheaply for each $ of EBIT. EBIT/EV is 14.7%, compared to peers' mean of 2.75%.

Catalyst

The main catalysts likely to happen with regard to Taro's operations are:

Taro's has committed an increasing amount of capital on developing new medicines and accelerated its ANDA (Abbreviated New Drug Application) filings. Currently, 36 of Taro's ANDAs are being reviewed by the FDA, one of which was tentatively approved. Taro recently filed 10 ANDAs with the FDA, of which four were first to file. Moreover, there are multiple products for which either developmental or internal regulatory work is in process.

In August 2013, NovaBiotics entered into an exclusive global licensing agreement with Taro for the clinical development, manufacturing, and marketing worldwide of Novexatin, a product aimed at the treatment of fungal infections of the toenail (Onychomycosis). Based on recent studies, Novexatin will deliver high cure rates and rapid cosmetic benefits with only 28 days of treatment against 330 days for the existing topical treatments.

My view is that the market is not correctly discounting the possibility that Novexatin will successfully launch in 2018-2019. In fact, from Taro's latest 20-F report, it can be evinced that the company has recently "received patents and obtained an exclusive license in the United States and other countries for a variety of products, processes, and methods of treatment, including a novel anti-fungal compound for onychomycosis". That statement (which was not reported on the 2014 and 2015 20-F files) gives a major hint about the several steps forward that have been done regarding Novexatin.

Revenues are expected to be in the range of $1-1.5 billion once Novexatin is launched as the market for such infection is relatively large and given the efficiency of the treatment.

Around $150 billion worth of drug patents will expire by 2020, which will allow generic drug producers to introduce new and cheaper products in the market.

Investment summary and recommendation:

Taro Pharmaceutical is a recommended buy with a price target of $175.

Taro Pharmaceutical Industries Ltd. (Taro, the company) is a science-based pharmaceutical company. The Company markets over 200 pharmaceutical products in over 25 countries and is largely known for its dominating influence in the generic dermatology segment.

Over the past three years, Taro has experienced stable growth along with operating and financial improvements. Metrics such as sales, net income, free cash flow, profit margins all improved, while debt was reduced to zero. Additionally, the company has a meaningful net cash position of $1.1 billion. Albeit the betterment of its operations, the market is pricing Taro at low valuations.

Company description:

Taro Pharmaceutical Industries is a multinational, science-based pharmaceutical company established in Israel in 1950. Taro is a leader in both the marketing and production of generic drugs and Active Pharmaceutical Ingredient ((API)) and sells its products in over 25 countries.

The Company operates principally through three entities: Taro Pharmaceutical Industries Ltd. (Taro Israel), and two of its subsidiaries, Taro Pharmaceuticals Inc. (Taro Canada) and Taro U.S.A.

Sun Pharmaceutical (SMPQY) currently controls 79.3% of the voting power in Taro.

Generic pharmaceuticals are the chemical and therapeutic equivalents of brand-name drugs and are typically marketed after the patents for brand name drugs have expired. Generic pharmaceutical products must meet the same quality standards as branded pharmaceutical products although they are generally sold at prices that are substantially lower than those of their branded counterparts.

Taro's generics (including semi-solids formulations, such as creams, ointments, and other dosage forms such as liquids, capsules and tablets) are the bedrock of its business and consist of more than 200 stock-keeping units, the majority of which are developed along with Taro's own API division. The therapeutic categories that Taro's generic drugs cover are Dermatology (66% of sales), Neuropsychiatric (20% of sales), Cardiovascular (8% of sales), Anti-inflammatory (3% of sales), and others (3% sales).

Taro manufactures API internally in its manufacturing facilities in Israel and Canada. This allows the company to control the quality of its products and to adopt an efficient and flexible approach to control supply. The vertical integrated production process of both generics and API enables the company to have a substantial cost advantage compared to peers.

Operating features:

Over the last three years, Taro has experienced an ample growth in terms of sales that increased around 42% and significant margins expansion. The company has concentrated its efforts on reducing costs, eliminating debt, increasing profitability and efficiency, and in committing more capital to research and development. Taro's increase in profitability was mainly driven by the introduction of new and high quality drugs in the market and by adjusting the prices of its products due to limited market availability of the respective drugs. These "pricing adjustments existed given these products were, and continue to be, of high quality and cost effective to patients compared to alternative treatment options available in the market". Taro's revenue in the United States accounted for 91% of total consolidated net sales.

Taro's market presence is balanced. Its customer pool is diversified among drug wholesalers, store chains, mass merchandisers, food and retail chains, medical care providers, and generic drug distributors.

Research and development expenses are allocated 65% to generic pharmaceuticals, 25% to proprietary pharmaceuticals and delivery systems, and 10% to organic and steroid chemistry. Over the last two years, R&D expenses grew 28%.

Taro increased its number of products in pre-registration (products that have passed the Phase 3 clinical trials and are awaiting regulatory approval before being launched for sale) from 27 in 2014 to 36 currently.

Cost of sales accounts for less than 18% of revenues, while SG&A expense accounts for less than 10% of revenues. Moreover, the company has lower labor force expenses and higher revenues per employee than most competitors.

Decreasing COGS, zero debt, and low SG&A expenses significantly reduced the cost structure of Taro, enabling the company to sell its products at a discount compared to competitors, increasing the company's market share and, consequentially, its free cash flow and cash position.

Cash flow from operations for the nine months ended December 31st, 2016, increased 34% compared to the same period last year. I expect free cash flow to be around $400 million for the fiscal year that ended on the 31st March 2017, increasing at an average annual growth rate of 15% over the last four years.

Taro's gross margin, net margin, and return on net capital are as follows:

Taro's ROE is 27%, and by analyzing it under a DuPont profile, it can be seen that it is driven by a large net profit margin and asset turnover rather than leverage, which is essentially not existent. Competitors not only have a substantially lower ROE but such value is principally driven by leverage rather than profitability and efficiency.

Market features:

In recent years, the market for generic pharmaceuticals has grown and is expected to keep expanding at a CAGR of 10.5% by 2020.

The growth has been fueled mainly by the following factors:

• The constant increase in brand drug prices is pushing demand for generics;
• Efforts by governments, employers, third-party payers and consumers to control healthcare costs;
• Increased acceptance of generic products by physicians, pharmacists, and consumers;
• The increasing number of pharmaceutical products whose patents have expired and are therefore subject to competition from, and substitution by, generic equivalents. Moreover, around $150 billion worth of drug patents will expire by 2020, which will allow generic drug producers to introduce new and cheaper products in the market.

Additionally, Taro is mainly focused on the market for generic drugs aimed at treating dermatological diseases such as eczema and psoriasis (of which around 13% of the US population is affected). Such market is a niche-high barrier to entry market. This allows Taro to sustain its extremely high margins by exploiting its predominant position as a leader provider of such generic medicines. A niche market will not persuade other large competitors that will have to commit extra capital in order to develop new drugs and that will be unable to sell at Taro's low prices because of their higher cost structure and operating leverage.

Management Operatus:

Taro's management has been able to execute a strategy focused on delivering high quality products. Taro's commitment to delivering quality products through R&D investments is one of its central priorities, and management has stated that building a strong and superior quality pipeline will continue to be its focus. In 2016, Taro received the supply chain excellence award from Cardinal Health, and the RBC 2016 Manufacturers award. Additionally, compensation expenses are relatively lower than the company's peers.

Taro's Board of Directors has recently announced that it approved a new $250 million share repurchase program, following the successful completion of the previous $250 million share repurchase program completed in August 2016.

Taro's management currently intends to retain the majority of its earnings to finance the development of its business. In fact, the company has recently expanded the production capacity of its Israeli and Canadian operations to meet anticipated greater demand for Taro's products in future years.

In May 2016, Taro's management announced that it will now make Keveyis, the first medicine approved by the FDA for the treatment of primary hyperkalemic and hypokalemic periodic paralysis and related variants, available to distributors at no cost for the treatment of primary periodic paralysis, in order to make the drug less expensive to clients.

Management has a tendency to operate conservatively. For example, from Taro's latest 20-F report, it can be evinced that the company does not ship products that have 12 months or less to expiration in order to reduce its exposure to any risk associated to a temporarily slowing demand for its medicines. Such peculiarity was not found on Taro's most direct competitors' financial reports.

Competition:

Taro's most direct competitors are: Teva Pharmaceutical, Akorn, Merck, Perrigo (PRGO) (2016 10-K form not yet provided), and Sandoz (Novartis's generic subsidiary).

All of the aforementioned companies have a substantially higher cost structure, more debt and lower margins compared to Taro. However, they are all trading at higher multiples.

Valuation:

Taro is an efficient performing business that is, however, barely covered by Wall Street analysts and thinly traded. Free cash flow per share is around $9, a value that is 2 to 8 times higher than closest competitors. Moreover, EV/EBIT is 6.8 compared to the peers' mean of 36.3. This indicates that the company is being valued relatively cheaply for each $ of EBIT.

EBIT/EV is 14.7%, compared to peers' mean of 2.75%. By running a fairly conservative DCF valuation, it can be evinced that Taro's current intrinsic value is around $175/share.

Investment thesis:

Taro has recently experienced an increase in pricing pressure. The market is expecting a decrease in sales and the challenging pricing environment for Taro to continue for the foreseeable future, hence its low valuation of 10 P/E. However, my view on the company's future is different. My investment thesis core tenants are as follows:

• Taro has committed an increasing amount of capital on developing new medicines and accelerated its ANDA (Abbreviated New Drug Application) filings. Currently, 36 of Taro's ANDAs are being reviewed by the FDA, one of which was tentatively approved. Taro recently filed 10 ANDAs with the FDA, of which four were first to file. To the extent that Taro is the first to market the generic version of a significant product, and particularly if the company obtains the 180-day period of market exclusivity for the U.S. market provided under the Drug Price Competition and Patent Term Restoration Act, sales and profitability can experience a sharp increase. Moreover, there are multiple products for which either developmental or internal regulatory work is in process.

• In August 2013, NovaBiotics entered into an exclusive global licensing agreement with Taro for the clinical development, manufacturing, and marketing worldwide of Novexatin, a product aimed at the treatment of fungal infections of the toenail (Onychomycosis). Novexatin will be the first fungal nail infection therapy to address both the underlying cause of the condition and the cosmetic issues associated with the infection. Based on recent studies, Novexatin will deliver high cure rates and rapid cosmetic benefits with only 28 days of treatment against 330 days for the existing topical treatments. My view is that the market is not correctly discounting the possibility that Novexatin will successfully launch in 2018-2019. In fact, from Taro's latest 20-F report, it can be evinced that the company has recently "received patents and obtained an exclusive license in the United States and other countries for a variety of products, processes, and methods of treatment, including a novel anti-fungal compound for onychomycosis ". That statement (which was not reported on the 2014 and 2015 20-F files) gives a major hint about the several steps forward that have been done regarding Novexatin. The market for such infection is about $6 billion a year, affecting 12% of the global population. Capturing around 25% of such market will lead to an increase in revenue of about $1-1.5 billion per year. Such scenario is relatively conservative considering the quickness and effectiveness of the treatment.

• Taro's competitive advantage lies in its proven compliance in manufacturing very high quality products.
• Taro has an ability to sell at lower prices than competitors given its cost structure.
• In addition to the pharmaceutical patents that have expired, there is a significant amount of patents related to dermatology that will expire in the following years, allowing Taro to capture additional market share.
• Taro has been able to sustain higher margins than almost the entirety of its competitors for an extended period of time. This means that the company is able to keep a competitive advantage in different market conditions.
• Near-term pricing pressure is being offset by increasing volume and by the launch of new products.
• Significant return on assets of 25% suggests that its operating results are sustainable.
• Taro currently has zero debt but a substantial net cash position of around $1.1 billion.
• Taro's internal vertical integration process gives it a meaningful competitive advantage.

Source of financial data: latest 10-K or 20-F form provided

(Editors' Note: This is a republication of an entry in the Sohn Investment Idea Contest . All figures are current as of the entry's submission - the contest deadline was April 26, 2017).

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.