ENDP’s Lower Guidance Not Much Of A Surprise; Negative Sentiment Remains An Opportunity

Endo Pharmaceuticals (NASDAQ:ENDP) reported 3Q 2012 adjusted EPS of $1.28, ahead of the Consensus estimate of $1.26. However, revenues for the period came in at $750.5 million vs. Street expectations for $789.4 million, and this shortfall, plus the company tightening its EPS outlook for the year from a range of $5.00-$5.20 to $5.00-$5.10, is putting pressure on the stock Monday. While EPS estimates were already reflecting the lower end of the prior guidance range (Consensus for 2012 was $5.03 prior to the call), management did not do a great job instilling confidence that key business lines will turn around significantly or soon. However, despite today’s lackluster earnings call, we believe ENDP’s attractive price and cash flow-generating power will continue to provide support for the stock.

Bright spots in the quarter were: 1) a better than expected gross margin; 2) lower than expected operating costs, which drove the earnings upside; 3) return to growth for Voltaren Gel after supply disruptions, suggesting ENDP’s marketing effort can get Opana ER growing again; 4) stabilization in Opana ER prescription demand; and 5) stabilization of the Women’s Health business in the American Medical Systems (AMS) division. ENDP is now trading at just over 5.0x long-term EPS estimates, and in the weeks ahead, investors will have an opportunity to observe prescription demand trends for Opana ER and Voltaren Gel. We believe that any growth for these important pharma products, plus information about the return to growth for the AMS division will be key to getting ENDP shares to turn around.

ENDP is cheap for a reason, and that is a lack of conviction that management can stabilize earnings by growing the rest of the business and cutting costs while the contribution from Lidoderm declines in 2H 2013. The 3Q earnings results did deliver on the lower expense side of the investment thesis, but management now needs to demonstrate that the growth side of the story is attainable. We believe that the stock will be very sensitive to Opana ER script trends through the end of the year, as well as any FDA guidance on whether it will approve generics for the old Opana ER formulation. We continue to like that the stock is trading as if long term earnings get cut in half, hence lots of room for error in owning ENDP, and the chance for significant upside if growth of key products and business segments become apparent. As noted in our report last week, buying once the earnings cliff has been addressed has proven to be a winning strategy for owning stocks of mature drug companies (Read the report here). Expect Wall St. analysts to reduce estimates and dump on the name between today and tomorrow, after which it makes sense to continue building a position in ENDP.