A Short-Term Problem Creates Long-Term Opportunity in Lannett Company

I use several different techniques to search for potential investment opportunities. But, there is no question that I strongly favor value investing because I like large margins of safety surrounding my money.

Another thing I do is closely follow businesses to which I have allocated capital, especially when the price falls 19% in about three months. In such a case, there exists a strong possibility that I missed something important in my original assessment.

There is also a reasonable possibility that it is simply another case of the market having mispriced a stock. In these cases, I want to determine whether a further allocation of capital is warranted.

Lannett Company—The business today

Lannett Company (LCI, Financial) is a manufacturer and distributor of generic drugs and is based in the U.S. The company has been offering drugs to treat indications and functions such as glaucoma, muscle relaxants, migraine, anesthetic, congestive heart failure, thyroid deficiency, gout, hypertension and others.

The company sells its products to drug store chains, private label distributors, online pharmacies, hospital buying groups and other high-volume distribution channels. Three of its top customers are:

AmerisourceBergen Corp. (ABC, Financial): 30%

McKesson Corp.: (MCK, Financial): 11%

Cardinal Health Inc. (CAH, Financial): 7%

As you can see, Lannett is not some here today, gone tomorrow operation. They are a serious business supplying products to some of the biggest names in the industry.

How is the business currently valued?

It can be difficult to be completely objective when trying to value a business in which I already hold a long position. I am always concerned that I will simply try to justify what I have already done. Therefore, when I am reassessing a business I currently hold, I start with a clean sheet of paper and ask if I would buy it today based on current facts.

On Jan. 8, Lannett’s share price closed the trading day at $35.99 per share. Based on the table below from Fidelity Investments, over the last 12 months of reported earnings (ended Sept. 30, 2015), the company has produced earnings of $3.98 per share. This produces a price to earnings multiple for the trailing 12 months of only 9.04.

For the current fiscal year ending in June, analysts covering the stock expect Lannett to earn $4.03 per share. For 2017 they are currently projecting $4.60 per share. This places the current valuation of the business at P/Es of 8.93 and 7.82.

So, we have a business that is very cheaply valued in an overall market that is anything but cheap. It is not stupid cheap. But stupid cheap is really hard to find in the market today, unless one wants to throw darts at the energy or mining sectors.

How does the future look for Lannett?

One of the precautions we must always take as value investors is to make sure that we are not buying businesses that are cheap because the industry or business is in decline. Just because a business is cheap and trading at the low end of its 52-week range, doesn’t mean that it can’t get much cheaper and the low end of the 52-week range get much lower. Just ask those who tried to catch a falling knife by buying shares of coal producers over the last few years.

In the case of Lannett, one of the big concerns that investors have had with the company was its relatively weak pipeline of “new” products and a somewhat limited range of existing products. Based upon currently available information, Lannett seems to be on the verge of alleviating this major concern with its pending acquisition of Kremers Urban Pharmaceuticals, currently based in Princeton, New Jersey.

Kremers brings a diversified commercial product portfolio of 18 products; a strong pipeline that includes 11 product applications pending at the FDA, of which five include Paragraph IV certifications, and 17 product candidates in various stages of development, including one 505(b)(2) product opportunity; and a recently inspected 300,000 square foot manufacturing facility in Seymour, Indiana. So much for a weak pipeline and limited range of products.

The company has stated recently that they expect this acquisition to be immediately accretive to earnings. This is excellent news to investors who are used to seeing a transition period between actual acquisitions and an accretive impact on earnings.

We can surmise that this optimism is already reflected in the analysts’ projections for 2017 earnings given the projected 15% jump. But there is reason for further optimism surrounding this acquisition.

Quite often a company acquiring another business will “sugarcoat” its intentions to soothe the feelings of existing employees in the business being acquired. That doesn’t seem to be the case with Lannett’s approach to its Kremers acquisition.

On Dec. 21, 2015, Lannett announced it plans to achieve approximately $40 million of cost reductions in the first 12 months after the acquisition is final and even more reductions in future years. Probably not the Christmas gift employees of Kremers were hoping for; but great news for Lannett’s long-term investors.

One of the coming changes announced at that time was that Kremers' corporate office would not continue to exist. When you are serious about cost-cutting, one of the best places to start is a corporate office. It tends to be where you find the highest salaries and the functions most easily and inexpensively consolidated into existing functions of an acquirer. Sadly, this is a rather uncommon approach but one that should bring existing shareholders to their feet in rousing applause.

The generic drug space is a spectacular place to be these days. Our aging population coupled with a near manic drive to reduce healthcare spending sets the table perfectly for booming sales of cheaper generic products, as the name brand drugs lose their patent protection in the coming years.

This was clearly illustrated in a 2015 conference call held by AmerisourceBergen when they revealed generic growth was about 50% year-over-year, now that they're sourcing generics for Walgreens (WBA). This was an exciting tidbit of information since AmerisourceBergen does not specifically break out generic sales in their financial statement. It was exceptionally interesting for shareholder of Lannett, since they are a major customer.

The FDA currently has a backlog of nearly 3,000 Abbreviated New Drug Applications (ANDAs) and is under tremendous pressure from both political parties to alleviate the problem. They have responded with the addition of more staff to speed up the process.

In short, it is hard to find anything not to like about the generic drug industry, and Lannett seems to be on the cusp of a dramatic improvement in their position within it.

Why does this opportunity exist?

It is quite common for shares of a company making an acquisition to fall leading up to the closing date. Quite often, the market believes the acquiring company has overpaid. I would actually agree with that sentiment in almost every acquisition I review. After all, if you are selling a business you operate, why would you turn it loose for anything less than it's worth?

Based on the benefits and cost reductions that Lannett expects to achieve from this deal, I can live with what looks like about a 10% overpayment for Kremers.

The market was already taking down shares of Lannett when the “bomb” was dropped in early November. It was revealed that a large customer of Kremers that account for approximately $87 million in sales was planning to transition their purchases to another supplier.

This sent already jittery investors running for the exits as fast as they could hit the sell button on their order screens. Lannett’s management has since stated that they have already begun to successfully place some of this lost volume with other customers and still expect the acquisition to be accretive in the first 12 months. This sounds quite logical since they are anticipating about half that amount in cost reductions during the first 12 months.

This looks much like a typical Wall Street overreaction of sell first and analyze the facts later. This is exactly the type of situations I look for when hoping to make some quick short-term gains over 12 to 18 months and truly spectacular long-term returns ranging into the triple-digit area over two to four years.

What is the upside for Lannett?

I think it all depends on your timeframe for an investment. I am dealing with this as both a short-term and long-term opportunity in terms of my own capital. Based on my own analysis of the business and the industry, I think the current analysts’ projections of 14% annualized earnings growth for Lannett are too conservative. I see this business, after fully integrating Kremers, as one capable of achieving growth rates of 15% to 17% per year. Because of that, I will use the analysts’ projections shown in the table below:

Based on the current year’s estimated earnings of $4.03 per share and a PEG (price to earnings growth) multiple of 1, a current fair price for Lannett’s shares would be $56.42. If we apply the same calculation to the projected earnings of $4.60 per share for the year ending June 2017, we would arrive at a fair value of $64.40 per share.

These valuations would result in capital gains of 56.7% and 78.9% respectively. My personal opinion is that these shares will more than double in the next 12 months given the industry in general and this business in particular.

I think the speed at which management is replacing the lost business of the one major customer and the spectacular growth in demand for generic drugs, coupled with the Kremers pipeline and faster FDA approvals, is a perfect storm for rapid profit growth.

Final thoughts and actionable conclusions

Lannett appears to be an excellent business in a superb and rapidly growing industry. The share price has been pummeled by panicked investors who have overreacted to what appears to be a very solvable problem.

The stock should be trading north of $50.00 per share right now with expectations for double-digit price growth over the next several years.

Instead, the market has handed us a truly rare opportunity to double our money in less than five years in a market that is somewhat overpriced. If you disagree with this assessment, I encourage you to save a copy of this article for five years and then check it to see which one of us is correct.

I don’t need to save a copy of this article as I am putting my money where my typing is. In the interest of full disclosure, you should be aware that I currently hold a long position in shares of Lannett. I have also sold $35 put options against the stock that will expire on Jan. 15. If the shares of Lannett are below $35.00 this coming Friday, I will allow them to be assigned to me and add them as a long position in my portfolio. I am also actively considering purchasing additional shares within the next two weeks as well as selling uncovered put options with a strike price of $30 per share and a Feb. 19 expiration if I can get a premium of at least 60 cents per share.