It seems to be a fairly constant theme in my articles that I like cheap businesses that provide essential products and services to their customers.
Today, I feel compelled to try one more time to point one out what represents one of the most compelling values in the market today. I published an analysis on this business at the end of December last year. It only attracted 457 page views.
I hope everyone who read the piece bought the stock. As of last Friday’s close, it is up 12.05% since the article was published on GuruFocus. This is an exceptional return for 10 and a half months. During the same period, the Dow, S&P 500 and NASDAQ have returned -4.14%, -2.14% and 1.99%.
If you didn’t buy at that time, the bad news is you have already lost 12%. The great news is that is a small amount to what is likely to come over the next 20 months.
The business was good and now it’s better
Aging populations can place a strain on countries with generous benefit programs for senior citizens. While these programs can create pressure on some aspects of an economy, other segments are virtually guaranteed to profit. As populations age, healthcare spending grows. As healthcare spending grows, pressure to control it grows as well.
One of the best ways to help control healthcare spending is to require recipients of health benefits to purchase generic drugs when filling prescriptions. This practice obviously benefits the businesses that manufacture and distribute generic drugs.
The factors that will drive the future of today’s recommendation remain completely unchanged from December of last year. Those readers who missed the original piece, or don’t recall the details can review it here.
Even though the business is the same and the factors that will drive future growth have not changed, other aspects of the business have. And those other aspects seem to have changed for the better.
As I stated last December: “With its currently low valuation, improving earnings projection and rock solid balance sheet, Lannett Company (LCI, Financial) currently offers investors a truly compelling opportunity to achieve spectacular returns on capital invested now, before the price rises.
Lannett Company develops, markets and distributes generic versions of branded pharmaceuticals in the United States. Its products cover a wide range of applications from treatments for glaucoma and migraine headaches to irritable bowel syndrome and HIV. One of the interesting aspects in reviewing the list of maladies for which Lannett has treatments is that most of them are chronic conditions rather than curable ones. This affords the company to acquire customers for life across many of the drugs it produces.”
How is the business currently valued?
The chart below from Fidelity Investments displays the actual EPS compared to the analysts’ projections for Lannett over the last eight quarters ended June 30. You can see from this graphic that the company has exceeded the analysts’ estimated in each of those reporting periods.
This chart also shows that over the last four quarters for which Lannett has reported earnings, it produced a total of $4.03 per share. Based on the trailing 12 months earnings, the company is trading at a very attractive multiple of only 11.7 times earnings.
But there is a bit more to consider in determining how cheap the current valuation of this business is. Last December, I revealed that the company was carrying a net of $7.68 per share in cash, receivables and inventory after subtracting all liabilities on the balance sheet. That was the number at the end of September last year; it is no longer true.
By the end of June, according to its own balance sheet, the company is holding cash, receivables and inventory equal to $8.44 per share net of the total liabilities of the business. If we subtract this number from the current share price of $47.21, we are left with a net share price of $38.77, or 9.62 times trailing 12 months earnings. With the S&P 500 currently valued around twice that figure, this is one cheap business.
The trend is our friend
Sometimes trends can change. Other times, the chances of that are slim to none. When it comes to the aging trend of the U.S. population, you can assign it to the latter prospects for changing.
The table below from the U.S. Census Bureau clearly shows the accelerating growth rate in the rising average age of America.
The percentage of the population over 65 years of age is expect to rise from 12.4% in 2000 to 19.6% in 2030. The number of Americans over age 65 is expected to reach 100 million by 2040. As the table above clearly shows, the real growth in our aging population will be in that group of persons aged 65 and older.
The piece of data below, stolen from my December 2014 article, shows that at age 65, healthcare spending begins to rise rapidly.
When you look a little more closely at the two trends above, you will see that we are currently right in the middle of the first decade where almost all of the growth in our 60+ population will be in the over 65 segment, right at the point where annual healthcare spending starts to explode.
What is the current fair value of the business?
Once I have determined sustainability of a business and its products and developed a case for the future potential growth. The next step in my analysis process is to always determine how the business is valued today compared to my view of how it should be valued.
This is not a fancy or complex process, it just takes a little time to pull all the numbers together. I do tend to tilt my analysis work to the conservative side since my primary objective in investing is not to lose money.
I like to look at the past five years performance of the business in regard to earnings growth rates and then compare that number to the analysts’ projections for earnings growth over the coming five years.
The table below, from Yahoo! Finance, shows earnings growth over the past five years has been a scorching 129.71% per year.
Going forward, the earnings growth rate for Lannett is expected to slow to 17.5% per year over the next five years. This projected slowdown could be contributing to the bargain price of the stock today as momentum investors flee.
For long-term value oriented buyers, this slowdown in growth rates can provide us with some level of comfort. We know that it is simply not possible to grow at 129% per year indefinitely. It is also very common for stocks that make the transition from hyper-growth to end up offering value oriented investors exceptional opportunities after the momentum crowd clears out at any price.
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There are a lot of metrics that can be used to assess fair value. When I am looking at a business with an ultra-safe balance sheet, solid products and exceptional past growth with good future prospects, a fair value estimate using a conservative price to earnings growth ratio (PEG) usually serves as a good starting point.
Depending upon the analyst and the business involved, the most popular PEG range used for establishing fair current value seems to be 1.5 to 2 times the forward growth rate times trailing 12 months, current year or next year’s projected earnings.
I use all three earnings values, but only multiply those by the projected forward growth rate just to provide a little extra measure of conservatism to the resulting fair value estimate.
Again, we can obtain the analysts’ estimates from Yahoo! Finance for the current year and the year ending in June 2017. Our actual earnings for the TTM period were taken from the chart above on the Fidelity Investments website.
| Earnings Estimate |
Current quarter Sept. 2015 |
Next quarter Dec. 2015 |
Current Year June 2016 |
Next Year June 2017 |
| Avg. Estimate | 0.88 | 1.01 | 4.12 | 4.86 |
| No. of Analysts | 5.00 | 1.00 | 4.00 | 3.00 |
| Low Estimate | 0.85 | 1.01 | 3.97 | 4.45 |
| High Estimate | 0.90 | 1.01 | 4.29 | 5.25 |
| Year Ago EPS | 0.94 | 1.21 | 4.04 | 4.12 |
In the case of Lannett, the company is projected to expand earnings at 17.50% per year for the next five years. Based on earnings for the trailing 12 months (TTM), the current fiscal year (ending June 30, 2016) and next fiscal year (ending June 30, 2017), we can produce the following estimates for current fair value:
TTM fair value: $4.03 X 17.5 = $70.525 Change from current price: 49.38%
Current fiscal year: $4.12 X 17.5 = $72.10 Change from current price: 52.72%
Next fiscal year: $4.86 X 17.5 = $85.05 Change from current price: 80.15%
Based upon these three measures of fair value, this stock is very cheap. With the projected forward earnings growth estimated at 17.5% per year, there is also exceptional upside in the shares even if the valuation multiples fail to improve.
The fact that the company has beaten the consensus earnings estimate in each of the last eight quarters reported also provides just a little extra margin of comfort when using numbers supplied by analysts. Since we don’t know the actual work quality or track records for any of these analysts, it helps to have some past performance to guide our confidence.
What is the current value compared to the historic norm?
When I am using a metric like PEG to assess fair market value, I also like to consider the current valuation compared to the historic norm for the business. In this case, the chart below shows that the median P/E ratio for Lannett is 24.68 times earnings. It also shows that if that median number were applied to the stock today, the shares would be trading at $96.10 per share or 103.56% above last Friday’s closing price.
By yet another measure of valuation that compares the current price of the stock to its own historic valuation, we again find this business to be cheap.
Even though it was mentioned at the outset of this article, we should keep in mind that the business is sitting on an absolute fortress of a balance sheet with a hoard of highly liquid assets worth 17.88% of its total market capitalization, even if the company chose to retire 100% of their total liabilities before calculating the value.
You don’t find this kind of protection in many businesses these days, and it should not be dismissed out of hand when you do. This is REAL value.
Final thoughts and actionable conclusions
The pressure to control individual health care costs will grow right along with our aging population. One of the easiest ways to accomplish this is to provide strong incentives for customers to choose generic drugs over the name brands.
Lannett’s business places it front and center in the path of irreversible trends in demographics and pressure to control health care spending. You don’t see slam dunks every day in the stock market. All indications are that we are looking at one today in Lannett.
If you chose not to buy on my last recommendation of the stock in December 2014, you have only lost 12% so far. Don’t ignore my advice again and lose the next 50% to 100% gains as well.
