HITK: A Promising Generic Drug Value Play
Market cap: $384M
P/E: 9.45 with losses from discontinued operations; 8.97 from continuing operations
Hi-Tech Pharmacal is a manufacturer of generic, branded over-the-counter, and prescription medicines. The company concentrates its efforts on liquid and spray products. The company experienced two years of stagnating sales and losses in 2007 and 2008 before returning to profitability in 2009 and seeing sales surge in 2010/2011 on the strength of its generic Flonase/Flovent product.
The relative valuation seems extremely appealing, perhaps due muted analyst projections for the coming year. According to data available on Reuters, even the most optimistic of the three analysts covering HITK expects 2012 sales and earnings to be below 2011 levels. Analysts are probably concerned because the FDA has stopped the sale of Lodrane, a cold/flu medicine that is the primary product of HITK’s branded prescription medicine division. I think that those projections are too pessimistic, but even if they prove accurate the company still provides reasonable value for the price over the long term.
I like that the company has three times as much cash as total liabilities, with no major spending commitments or off-balance sheet liabilities. The only contracted purchase was $1 million worth of supplies and equipment that was completed in FY2011. Free cash flow has generally been positive throughout the past 10 years, except during the rough patch in 2007-2008. I see this as a positive sign from a business and shareholder perspective. Since the company produces enough cash to fund its working capital increases and capital expenditures with significant money left over, it is not dependent on outside capital to grow or survive. This contributes to its strong balance sheet, which enables it to survive in difficult times. Two benefits from a shareholder point of view are the lack of dilution (as it’s able to fund growth internally) and the availability of cash for stockholder-friendly actions like buybacks.
HITK is not an asset-based value investment. The current market cap is more than twice the total asset value of the company. Licensed and patented drugs are definitely valuable assets for the company, and perhaps more valuable than their carrying value might reflect, but its most significant products are not their own intellectual property and in any case would not vastly increase net asset value.
Both sales and earnings have grown very rapidly over the past few years. Obviously investors are somewhat skeptical that this will continue, else the stock would not have a P/E of under 10.
Much of the growth has been supplied by the skyrocketing sales of generic Flonase. The valuation is in part the result of this product concentration. It’s important to note that most other areas of the business also experienced growth in FY 2010 and FY2011. Runaway success with fluticasone was very helpful, but others products also seem to have appeal in their niches.
Concentration does present a risk, but only a modest one. Flonase is an established product rather than a speculative development or new drug. It has been on the market for 17 years and thus has a mature market. It also has a fairly sizable one – four years after the expiration of their patent on fluticasone propionate, GlaxoSmithKline (GSK) still reported sales of 800 million pounds. For this reason I would expect that fluticasone sales, while they might not grow at the prodigious rate of the past year, would at least remain steady. It’s an accepted product with a stable market. The age of the product also reduces (but does not entirely eliminate, I must admit) the risk that catastrophic side effects would be discovered and lead to bans or litigation.
It might appear self-serving or dangerously optimistic to dismiss the the negative views of analysts to present a bullish case, but I think there are concrete reasons to question their conclusions. The first is their consistent underestimation of the company’s prospects for the past four quarters. Future FY estimates that were founded open overly pessimistic quarterly estimates are also going to underestimate future performance.
Second, the rapid growth in fluticasone market share from quarter to quarter means that even maintaining the market share achieved in fourth quarter results in a modest amount of revenue growth. Observe this chart of past and potential FY2012 sales:
I figure that fourth quarter and first quarter (February through July) will probably be the periods of peak allergy season and therefore the peak sales period and assigned those $27 million in sales, essentially what the company achieved in the fourth quarter. The off-peak quarters get a slight increase in this scenario to account for the large increase in market share achieved in fourth quarter. The loss of Lodrane from the product lineup is expected to reduce revenues for the branded prescription segment ECR by $16 million. As you can see, a flat market share for Flonase suffices to overcome much of the shortfall from losing Lodrane. If fluticasone sales continue to rise, then the shortfall definitely disappears.
For a business where the biggest products are quite literally generic, quality management is crucial. One measure is consistently strong returns on invested capital. Over the past ten years HITK has achieved an average ROIC of 15.7%. Recent years have been even better, with a three year average above 24%. I prefer to focus on the first value, however, since I want to measure the success of management policies in general rather than just the single (obviously quite successful) decision to market fluticasone. This demonstrates a comforting long-term record of effectively allocating capital.
HITK’s focus on liquids, creams, and sprays builds a market niche. Their goal is presumably to take advantage of scale effects and strong reputation within their markets. According to company claims (which are difficult to properly verify without access to IMS sales data), 70% of their products were first or second in their respective markets as of 2010.
The biggest risk is of course that something will curtail sales of fluticasone or drag down its margins. As I mentioned above, the drug is old enough that surprising new effects are unlikely. Margin compression is a more likely possibility and the effects can be seen the in decreased importance of HITK products like dorzolamide, which has seen unit sales increase but sales prices decline drastically. This resulted in declining revenues from that drug despite its increasing sales. A quick scan of the SEC filings of other generic drug manufacturers (Mylan, Watson, etc.) did not suggest that any other big players were planning to enter this market, but it’s something to keep a watchful eye on.
There’s also management risk. Recent product decisions have performed well for the company, but many others have not. The acquisition of Midlothian Labs proved unwise and that company was recently divested at a modest loss, as was a previous were previous unsuccessful product acquisitions like Brometane and Naprelan. If the company hit a rough streak where these bad decisions outweighed the positive ones, investors would be in for a rough ride. Since the nature of the industry requires a constant search for new and better medicine, investors need to watch management carefully for signs that they are losing focus or making careless/overpriced acquisitions. The high cash balances make that a major point of concern, since rising ability to make purchases often becomes a rising incentive to buy regardless of price.
Another risk is the family element. David Seltzer seems to have demonstrated solid leadership, but the expensive involvement of his brother Reuben is troubling. Reuben Seltzer (a director and major shareholder) provides “legal and new business development services.” I suspect but cannot prove that this is a simply a cushy family job. Total payments to Reuben Seltzer in 2010 were $435,000 – nearly as high as David Seltzer’s salary (only $16,000 less) and 67% greater than the next highest paid corporate officer. I would also point to his lack of direct knowledge or experience in the field and his presumably disastrous tenure at Neuro-HiTech, a company where he was CEO and where the current value of HITK’s entire investment would perhaps pay for a nice meal. HITK is currently a 17.7% partner in a joint venture alongside Reuben Seltzer and is also invested with EMET Pharmaceuticals (where Reuben is a principal) developing generic drugs in a pharmaceutical field that is admittedly “outside of its area of expertise.” Between the money paid to Reuben in FY2010 and the $713,000 in R&D funds allotted to the EMET project over $1 million was spent on the man last year. HITK could benefit substantially from ending this relationship, but realistically that will never happen and he will continue to be a modest liability for the company in years to come. It looks like HITK did a bit of work between the 2011 and 2010 annual reports to obscure the resources he is consuming, so I’ll probably do another post to take a look at that.
Before the fourth quarter financials came out, I would have listed the buildup of inventory as a potential sign that the company was betting too heavily on continued sales increases. The increase was not extraordinary, but it did exceed demand and might have signaled declining growth. Demand clearly proved to be present, since sales were up 45% in fourth quarter and 20% for FY2011. Accounts receivable, on the other hand, became more of a concern on the FY2011 statements. Receivables were up 45% year-over-year whereas sales were up only 20% and earnings 33%. HITK claims that there was a surge of orders late in March/April that have yet to be collected on, but that is certainly a substantial jump. I’ll probably want to do a bit more digging there as well.
In spite of the concerns listed above, I feel cautiously optimistic about HITK. It’s not a high-concentration bet (not with those receivables), but it appears to be a simple and undervalued way to tap into the generic drug market.