As we wrote last week, Endo Health’s (ENDP) newly appointed CEO and former Valeant (VRX) operating star Rajiv De Silva is on the road with institutional investors outlining his strategy to reposition the company for stability and growth. De Silva began a multi-city roadshow this week, and investors who have met with the company thus far note that they are confident the new CEO’s track record and initial plans will start to have impact soon. The underlying business faced strong headwinds last year, and ENDP shareholders felt the pain. Although shares fell by 25% over the course of 2012, PropThink saw the depressed stock and the perceived threats to the business as an opportunity late in the year, and since the departure of Endo’s former CEO and the entrance of De Silva in February, we’ve become even more bullish about this Specialty Pharmaceutical company. De Silva has a strong history of creating shareholder value at Valeant Pharma through creative acquisitions, divestitures, and unique corporate strategies. Additionally, his background as a McKinsey consultant means execution on improving current operations and taking the business in new directions. In fact, we’ve been told that McKinsey consultants are currently helping him with the ongoing turnaround at Endo. Essentially, the message being delivered to investors is that De Silva will act fast in making changes, the most important being significant operating cost reductions, investment in generic manufacturing capacity, and “tuck-in” single product acquisitions to diversify the business. We believe ENDP shares remain cheap at less than 6x forward earnings, and as more investors meet with the new CEO, we would expect the stock to continue to trend higher
Financial flexibility to execute on a broader plan. De Silva is comfortable with the business, its positioning, and most importantly, he’s comfortable with the balance sheet, particularly the current level of debt, which he could see increasing if needed to bring in attractive assets. He’s willing to trade the balance sheet for income statement benefits, a smart strategy in the Specialty Pharmaceutical space where investors value companies based primarily on sales and earnings multiples. What’s he looking for? He likes ENDP’s existing business segments – women’s and men’s health, pain management, and generics – and doesn’t believe that he needs to stray far from the path when bolting on new products. There are plenty of tuck-in acquisitions out there, says De Silva, and taking advantage of “one-off” products can be a good strategy for obtaining approved drugs or devices at attractive prices. Many companies with single products don’t have the resources to create success alone, and it’s simply a matter of finding the products in which ENDP’s sales and distribution efforts can build a sizeable brand drug in its areas of focus. Part of the secret to success at Valeant was the acquisition of assets that were under-the-radar, a strategy that De Silva is likely to implement at Endo. Sources said that they would not be surprised to see activity on the acquisition front relatively quickly.
Generics business ripe for investment. De Silva is taking a more aggressive approach to expanding Endo’s generics business, as this is among the higher growth units at the company, and there is simply more business than the company’s current manufacturing capacity can handle. De Silva indicated that he plans to ramp up capital expenditures in the near-term to build generic manufacturing capacity and capture this business. Given the high margins on niche and pain management generics, we believe this segment will remain a shining star of the company. It’s a comparatively inexpensive way to bring new products into the fold, and with the threat of a generic products looming over one of its own value drivers, Opana ER, steering the company deeper into generic production makes sense.
Operating efficiencies a major focus to re-align the business and mitigate risk. Investors told us that De Silva has plans to bring significant cost-cutting strategies into play that should either be accretive to the bottom line, or protect current profitability in the event that negative scenarios play out. In short, investors should be confident in the company’s ability to put up $4.00 or more in EPS. De Silva believes the company has significant flexibility in operating costs. Rajiv was a McKinsey operating consultant early in his career, and sources say that he engaged McKinsey to help him review the business and identify areas to optimize. De Silva has noted that G&A costs at Endo are 2x what they are at Valeant as a percentage of sales. Endo reported 2012 SG&A of $898M on revenue of $2.3B, or 39% of sales. For comparison, Valeant reported 2012 SG&A of $756M on sales of $3.3B, or 23% expressed as a percentage. If De Silva can reduce G&A at Endo in the same way that he did at Valeant, cutting these costs by almost half, we estimate it could drop $100M or more to the bottom line.
New growth strategies aside, expense cuts like these could be highly accretive to Endo’s earnings but also offer financial flexibility if needed to play defense. To that end, De Silva acknowledged the risk that the current form of generic Opana ER could stay on the market, but believes that current 2013 guidance – lowered significantly by former CEO David Holveck shortly before his departure – is low enough that the company can meet estimates regardless of generic erosion. The confidence is encouraging given the uncertainty regarding Opana ER, and demonstrates what we opined last year: that ENDP had finally lowered the bar far enough to predicate a top- and/or bottom-line beat. At the hand of De Silva and his consultants, the leeway to meet financial expectations could be even broader. Of course, if generic Opana ER is removed from the market, which still has a reasonable chance of happening, it would be pure upside to estimates, and would send the stock skyward.
Divestitures possible, but not in the near-term. In terms of divestitures, we’ve been told that the new CEO does not see anything he wants to get rid of as of yet, nor would he sell divisions off at fire-sale prices. Although there are weaknesses in some of Endo’s subsidiaries, it seems De Silva believes that rebuilding these businesses is possible and prudent, before deciding to divest them to raise cash. In particular, the women’s health business is an area of focus that needs repair.
Repositioning the tax structure? In the footsteps of Valeant, there’s the possibility for De Silva to go after another company in a tax jurisdiction with a significantly lower income tax (outlined in our previous article). Valeant moved itself through a unique merger into foreign jurisdictions, where income taxes have a materially beneficial effect on its bottom line. While this is definitely an option, De Silva is after high quality assets first, and a favorable tax jurisdiction would be a plus. If Endo were to make a move toward a lower tax jurisdiction, we think investors would reap significant rewards.
De Silva’s plans thus far are resonating with investors that have heard the early approach. Based on the conversations, we believe there are several news items that could materialize rapidly and energize the stock, such as: announcements of new operational managers, cost cuts, and tuck-in acquisitions, notwithstanding the possible upside scenario that generic Opana ER is removed from the market by the FDA (decision expected in May). For technical analysts, price action has formed a clear bullish pennant over the last month, and with what we suspect will be good news on the horizon (like a product acquisition), ENDP is set up for a breakout higher. ENDP’s 50-day and 200-day moving averages formed the lauded Golden Cross just last week. Overall, De Silva’s track record suggests that execution on his strategy marks a turn-around point for Endo Health. We believe that the former management team has reset the bar low enough (in terms of 2013 guidance) that De Silva can deliver even as he gets the ball rolling on a number of new initiatives. And with the possibility for material announcements in the near-term, ENDP is positioned to move higher.
