ENDP’s Deep Discount Won’t Last; Upside Scenarios Are Icing On The Cake

Shares of Endo Pharmaceuticals (NASDAQ:ENDP) are trading at a deep discount to other pharmaceutical companies, with the last dip in price coming on the heels of guidance at the company’s recent Analyst Day (see our prior story). Based on the company’s outlook, 2013 revenues are expected to be in the range of $3.0-3.2 billion, with EPS ranging from $5.20-5.40. While the high end of revenue guidance just graced Wall Street’s $3.2B average estimate, EPS guidance came in lower than the $5.51 Consensus forecast.  As a result, shares of ENDP fell after the meeting had ended and continued to slide to the $29 range. So why is lowered guidance bullish for the stock? The answer: the resolution of the “earnings cliff” and ENDP’s very low P/E multiple. The earnings cliff and how to invest based on this common phenomenon in the drug industry is explained below. A key to the investment thesis is that despite the anticipated 2013 launch of a generic version of Lidoderm, ENDP’s largest product, the company’s agreement with generic drug company Watson Pharmaceuticals (NYSE:WPI) has smoothed out the impact of declining contributions from this important earnings component. On both near- and long-term earnings, ENDP is now too cheap to ignore, and investors are starting to recognize that the heavy discount on future earnings presents a buying opportunity.



Buying Drug Stocks After The “Earnings Cliff” Has Been A Winning Strategy. Lidoderm is a topical patch that delivers the anesthetic agent lidocaine to the skin to alleviate pain. The drug is expected to achieve peak sales of approximately $950 million this year, but will begin to decline next year on the entry of generic competition.  The ENDP story is far from the first time that investors have dealt with drug companies losing major products to generic competition. Note that P/E multiples for major drug companies fell to around 7x forward earnings, when firms like Pfizer (NYSE:PFE), Eli-Lilly (NYSE:LLY), and Sanofi Aventis (NYSE:SNY) were set to lose their biggest earnings drivers; Lipitor, Zyprexa, and Plavix, respectively, to generics. What’s key, is that once these companies were within a year of generic entrants and earnings estimates reflected their approaching earnings trough, P/E multiples for these stocks were able to expand, as the uncertainty around long-term earnings had been lifted. In fact, major pharmaceutical companies now trade, on average, at 11.3x forward earnings (see above), despite the continued lackluster outlook for the industry.

Lidoderm Settlement A Great Move By ENDP; Upside Potential Exists. The opportunity to own ENDP is similar to big pharma companies after earnings cliffs were fully modeled and valuations overcorrected in front of trough earnings. Note that both PFE and MRK each have climbed 45% from trough to peak in the last 52 weeks, despite major earnings drivers Lipitor and Singulair losing patent exclusivity this year. With WPI preparing to launch its generic Lidoderm in September 2013, and the company’s Analyst Day clarifying earnings after this event, now is the time to get involved in ENDP. Moreover, unlike big pharma companies, which lost most of the economics to generic versions of their top products, ENDP was smart enough to enter into a legal settlement with WPI when Lidoderm’s patents were being challenged in court. Based on the settlement, WPI cannot launch its generic Lidoderm until next September, and ENDP is entitled to receive 25% of gross profits from WPI’s generic Lidoderm.  Note that the terms of this settlement are not applicable if another generic comes to the market, and if that occurs, ENDP would likely launch its own generic. Nevertheless, thus far no other generic has received FDA approval. Mylan Inc. (NYSE: MYL) is thought to be the closest to market, but past generic Lidoderm candidates, specifically those using the technology in MYL’s formulation (an acrylic formulation), have been unsuccessful in replicating the Lidoderm brand to FDA specifications. In fact, WPI was using this same technology when it finally abandoned the project and switched to using the same formulation approach as the original Lidoderm brand (hydrogel technology), hence the patent challenge by WPI and subsequent settlement with ENDP.

ENDP has its own generic division, called Qualitest, and it is likely that the managers of this business unit were instrumental in ENDP's proactive approach by getting in front of the generic Lidoderm threat, settling it, and bringing it in for a soft landing. Assuming there is only one generic version (WPI’s) on the market for several years, the discount to brand is likely to be relatively small, and this could enable ENDP’s brand to keep a larger-than-usual share of the market. Typically, generic entrants will penetrate up to 90% of the brand market on a volume basis within 6-9 months of launch, and with multiple generics on the market, price will usually fall by 85-95%. This recently happened with generics to Merck’s Singulair product, which has been decimated by the new cheap competition. However, under a scenario where a sole generic Lidoderm comes in at roughly a 15%-20% discount, not only will pricing remain robust, but the actual brand product could retain 25-30% of the market in terms of unit volume. As long as no new generic gets approved, this scenario would likely be sustainable, with WPI benefitting from a large and profitable generic product, and ENDP holding on to way more of the market than typically seen, plus the 25% share of profits on WPI’s generic. Based on guidance from ENDP, the additional upside to earnings if only WPI’s generic comes to the market calculates to about $0.60 per share, and notably, Wall St. Consensus expectations are already discounting in Mylan entering the market in 2014. Analyst’s average EPS estimate for ENDP in 2014 is $4.72, suggesting that if MYL doesn’t get to the market, there is approximately 12% upside to earnings expectations on the single generic Lidoderm thesis. Note that even if MYL does get to market, shares of ENDP remain cheap on earnings under that scenario. Either way, investors win.

Opana ER Growth Acceleration Will Move ENDP Higher. Opana ER is ENDP’s  extended release formulation of oxymorphone, a highly potent pain medication and a key driver of the company’s future growth. The drug is indicated for the relief of moderate to severe pain in patients requiring around-the-clock opioid treatment for an extended period of time. After the company launched Opana ER and took sales up to $384 million/yr. and growing, manufacturing partner Novartis (NYSE:NVS) experienced supply issues, short-circuiting the product’s growth trajectory. In addition, ENDP reformulated Opana ER as an abuse resistant product, and in June the company removed the old Opana ER formulation from the market. Notably, the FDA added the former Opana ER formulation to its discontinued products list. The reformulated product required some doctor education regarding the new formulation’s benefits and “sameness” in terms of efficacy to the old formulation. Doctors question reformulated pain medications on skepticism that they may not work as well as the original product, worrying that patients could complain. However, this is not the case with the new Opana ER formulation; efficacy between the old and new product is exactly the same. After the supply disruption and switch to the abuse-resistant formulation earlier this year, total prescriptions for Opana ER declined and the mix of prescriptions has trended toward lower strengths of the product (which carry a lower price). The new Opana ER is has an annual run-rate of about $320 million, and because of the recent ‘flat’ prescription trends, analysts have lowered their revenue and growth expectations for the drug. The company expects prescription trends for Opana ER to stabilize by the end of the year, with a return to growth in 2013. As a result, re-acceleration of Opana ER prescription trends will send shares of ENDP higher.

Despite discontinuation of the old Opana ER formulation, there is potential for a generic version of this product to come to the market in January 2013, which is also weighing on analyst’s expectations and enthusiasm for the stock. However, the company has already shifted 90% of sales to the new abuse-resistant form. Importantly, a generic for the old Opana ER won’t be directly substitutable (AB rated by the FDA) for the new formulation, therefore, brand sales are not really at risk. In order for the generic to be dispensed assuming the FDA approves it, doctors would have to write a prescription specifically for the generic of the old formulation. Because the old formulation was removed by ENDP for safety reasons (high abuse potential), the FDA may in fact, be reluctant to approve a generic for the old formulation, and no FDA approval for the generic would be good news for ENDP as all doubt about Opana ER as an exclusive brand would be removed. ENDP still expects long-term peak sales for Opana ER at $800 million annually, given the new formulation’s patent life out to 2029, but because of the slower sales ramp and perceived generic threat, analysts are modeling Opana ER conservatively.  As a result, a pickup in prescription trends for Opana ER and/or the FDA deciding that no generic Opana ER (old formulation) will be approved, are both events that will drive ENDP shares sharply higher.  Even if a generic for the old Opana ER is approved, the impact to the new formulation is likely to be minimal. We’ve seen this kind of situation before when Teva Pharmaceuticals (NASDAQ:TEVA) received FDA approval for generic TriCor (Abbott’s triglyceride reducing medicine), however, Abbott (NYSE:ABT) had converted all of its sales to new a TriCor line with different dosage strengths. Unfortunately for TEVA, there was almost no substitution to its generic version because it was not directly substitutable to the new TriCor line and doctors had stopped writing for the old strengths. A decision by the FDA on whether or not a generic for the old Opana ER formulation is approvable is expected in the next couple of months, a key catalyst for ENDP.

Strong Cash Flow Supported By Diversified Lines of Business, Pipeline Is Largely Free. Other components of the story center around: 1) ENDP’s generics business, Qualitest, which continues to grow at double digit rates and is expected to have stable to expanding gross margins on niche generic products; 2) The company’s American Medical Systems division, a device and services business, focused on Urology and Women’s Health and growing on an accelerated basis with expanding margins; and 3) ENDP’s drug pipeline which is getting virtually no credit from the market and features products like Aveed (testosterone injection, resolution of FDA complete response letter issues expected next month), BEMA Buprenorphine (novel pain drug, Phase III results expected in 4Q 2013), and Urocidin (bladder cancer treatment in Phase III). For reference, the Qualitest division is expected to represent about 21% of sales this year; American Medical Systems (plus the Healthtronics business) is expected to contribute 24% of 2012’s sales base; with ENDP’s brand drug products comprising the remaining 55% of revenues. With no new business or product acquisitions, Endo’s brand drug sales are expected to represent just over 40% of sales by 2014, with the other two business segments growing to fill the Lidoderm erosion gap.

Important for value investors, ENDP offers significant cash flow, with a current cash flow yield (free cash flow/ enterprise value) of approximately 10%.  Management expects to shrink annual operating expenses by $150M between now and 2015 by reducing promotional resources behind Lidoderm and other cost containment initiatives. This should help keep earnings relatively steady over the period when Lidoderm  brand sales fade away. With its excess cash, ENDP continues to pay down debt and buy back stock, thereby positioning the company to drive more leverage to the bottom line.

ENDP noted at its Analyst Day that it re-purchased $100 million in stock in 3Q 2012 as part of its current authorized $450 million share buyback program. It intends to make further open market purchases of its own stock through the end of the year. Another use of cash could be on business development activities, and we note that Specialty Pharmaceutical companies can be rewarded for acquisitions of businesses and/or products that can instantly boost earnings (aka “accretive acquisitions”).

Very Favororable Risk-Reward; Scarcity Value Should Attract New Money. What we like most about ENDP is the favorable risk/reward proposition offered by the stock. At less than 6x forward earnings, P/E multiple expansion alone could easily drive 50% upside or more, based on the peer comparisons above as investors get comfortable with the company’s long-term EPS guidance and analyst forecasts. The company is set to report earnings next Monday (November 5th at 8:30am), and the 3Q earnings call could give investors further comfort. Given where the peer averages are indicating, once could argue that ENDP is currently pricing in just half of the EPS expected over the next couple of years. This indicates a very low level of risk associated with the stock. Looking at this from a cash flow perspective, ENDP expects to deliver cumulative EBITDA (operating cash flow) of more than $3 billion from 2013 through 2015, meaning that the company has the ability to replace all of its current market value via cash flow in just a short period of time. Some are looking at ENDP on a sum-of-the-parts basis. In doing so, the segments of the business are valued in the table below, and suggest that ENDP has potential to trade significantly higher, be taken out, or broken up to unlock shareholder value.



Supporting the “take-out” or “break-up” prospects, the company has indicated that it is exploring succession plans for CEO, David Holvek, who is now 66 years old. Assuming a new heir-apparent is brought in to run the company, the stock would likely rally on this news given the multiple potential strategies to create value and a new executive seeking to take charge and win over investors. Lastly, it is important to mention that there is scarcity value with ENDP, as there aren’t many mid-cap names with this kind of upside potential and relatively low risk profile. As a result, I expect investors to come around on this name after earnings are reported and after the election, when the broader markets are more stable.