Description

Investment Thesis

Caraco has annual $350M in sales and $32M in net income. The company has almost no CapEx, zero debt, and over $33 in cash. The company sells for a market cap of $144M and an EV of $110M, an EV-to-earnings multiple of 3.4x. The management has publicly stated a 25% sales growth for FY 2009 and should be growing revenue in high double-digits after that. At current prices, you are getting a dollar for 30 cents.

The main drag on the stock price is the current credit crisis and a recent FDA warning on quality control. The FDA recently issued a letter to Caraco for quality-control issues at its manufacturing plant. The FDA can withhold the approval of pending drug applications until the issue is resolved. The company has a history of complying with the regulation and has stated it will get it fixed quickly. Also, while the current quality-control issue is being resolved the company can still manufacture and distribute its already approved drugs. So the current FDA warning will not stop the company current operations. 

The Business

Caraco Pharmaceuticals is a generic drug producer in a highly competitive market. Once a branded drug comes off patent, a generic drug producer can sell its product in direct competition with the branded drug. A generic drug product is one that is comparable to a branded drug in dosage form, strength, performance characteristics, among other criteria. The generic drugs are not required to include preclinical (animal) and clinical (human) data, since the branded drugs have already passed the testing. This makes it a huge cost advantage for the generic drug and also expedites the process from R&D to distribution.

The 1984 Hatch-Waxman Act (also known as Drug Price Competition and Patent Restoration Act) was a major turning point for the generic drug industry. Hatch-Waxman established the criteria which has become the foundation of generic product approval. The process to produce a generic drug is: generic drug producer files an Abbreviated New Drug Application [ANDA] with the FDA. FDA reviews the application for many criterias including whether the drug meets the bioequivalence and patent violation. Once the FDA approves the application the generic company can begin to produce the medication. The entire process usually takes around 12 to 18 months, although with the current backlog it can take longer than 18 months.

If the generic producer is the first company to file a generic drug application for a branded product, the company receives a Para IV status. The Para IV status allows the generic drug maker a 180 days exclusive distribution of the generic. This allows the generic drug maker to gain from high margins before other generic drug manufacturers enter the market and lower prices.

The generic drug industry is expected to grow at a healthy rate going forward. With a number of  blockbuster drugs losing patent in the next 3 yrs, the generic market is expected to grow at double-digit rates from 2008-2011. The generic market is expected to generate over $69 B in revenues by 2011.  

The Company

Caraco Pharmaceutical Laboratories is a Detroit based generic drug manufacturer. It has its manufacturing and distribution facilities located in Detroit but has a major backing from a big international pharma company. Although it is a small cap company, it low-cost manufacturing coupled with the backing from a big pharma company, Sun Pharma, provides it with R&D and manufacturing capabilities that allow it to complete with much bigger companies.

The company has been growing at a torrid pace. In FY 2008 the management predicted 35% sales growth. The company delivered almost 200% growth. For FY 2009 the management predicts 25% sales growth. In the first six months of the FY, it has produced over 78% growth.

The company has a strong pipeline of drugs awaiting FDA approval. The company currently has 23 generic drugs awaiting approval. The company has received 4 approvals this FY. Also, it has a distribution agreement with Sun Pharma, which allows Caraco to market and distribute Sun Pharma’s generics. The Sun Pharma and Caraco pipeline includes 88 filings awaiting approval, with Sun Pharma providing guidance for filing 30 new drugs for approval in FY 2009. The company has a strong future and growth.

Compared with other generic drug producers, Caraco is one of the smaller companies in the industry. Caraco currently has a market cap of 145M, compared to the leaders in the industry: Teva (34B), Mylan (2B), Watson (2B), Perrigo (3B). Caraco’s sales are much smaller than competition. Caraco had $350M in sales in FY 2008, compared to Teva ($9B), Watson ($2.5B), Mylan ($2B), Perrigo ($1.8B).

By market cap, the company looks small compared to its peers. Although, the company’s partnership with Sun Pharma gives it access to R&D facilities that its peers enjoy. This is at the core of the value proposition of Caraco, for some reason the market hasn’t realized this yet. Sun Pharma has publicly stated that it expected huge growth in the US market and Caraco has been the major driver for this growth. Also, with Sun Pharma’s recent acquisitions, Caraco is positioned to benefit enormously.

The Caraco and Sun Pharma Relationship

Sun Pharma is one of the largest pharmaceutical companies, the largest via market cap, in India. It owns about 76 percent of Caraco, including both common and preferred stock. Sun is the largest drug company in India, valued by market size, at over $5 billion.

In 1997 Caraco was struggling to survive. The company had $28M in accumulated losses and practically no ANDAs awaiting approval. The company had a FDA approved manufacturing site in Detroit but with no ANDAs awaiting approval, it was like a zombie.

During that time, Sun Pharma was looking to enter the US generic market. In 1997, Sun Pharma made a purchase of 5.3 million shares for $7.5 million. Sun Pharma also provided over $9.7M in debt. Sun Pharma’s investment in Caraco was the turnaround point for the company. Not only was capital provided to Caraco, Sun Pharma put in place its own management team to lead the company back to growth and profitability.

In August of 1997, Caraco entered into a technology transfer agreement with Sun Pharma. Under the terms of the pact Sun Pharma was to transfer 25 generic products in exchange for 544,000 shares apiece over a five year period. The technology transfer for each medication took place once a bioequivalency test was completed on the generic drug. Sun Pharma transferred 13 drugs under this agreement.

In 2002, Caraco and Sun entered into a new technology transfer agreement. Similarly to the previous arrangement, Sun Pharma agreed to supply Caraco with 25 generics over a five year period in exchange for 544,000 preferred shares apiece. These preferred shares are not convertible for three years. As of the most recent quarterly filing all 25 products have been selected for transfer and have passed bioequivalency tests.

Under both of these agreements Caraco had the right to sell products in only the United States and Puerto Rico. Also, Caraco expenses all technology transfers as R&D expenditure on its income statement. In Caraco’s quarterly and annual SEC filings they expense the technology transfers as non-cash R&D expenditure at the current market value of Caraco’s shares.

In FY 2007 Sun Pharma and Caraco entered into a marketing agreement where Caraco will market and distribute Sun Pharma’s products. The margins on these marketing and distribution products is capped at 10% for Caraco. Although the margins are much lower than the manufactured products (with are around 46%), Caraco gains an additional source of revenue stream.

In FY 2008, Sun Pharma and Caraco entered into an agreement where Caraco will market and distribute Sun Pharma’s Para IV products. Caraco’s margins are capped at 8% for these Para IV products. Although the margins are low, Sun Pharma’s Para IV are usually for multi-billion dollar branded drugs. The agreement provides another additional source of revenue stream for Caraco.

In 2005, Sun Pharma purchased a manufacturing facility, out of bankruptcy, in Ohio. Although Sun Pharma hasn’t done much with that facility, recently Sun Pharma took one of its top executives from Caraco and placed him in charge of the Ohio plant. Also, Caraco has signed multiple agreements with a third-party for distribution and marketing of products. Caraco currently had agreements to produce 4 different products with unaffiliated third party firms. It is very likely that Sun Pharma sees Caraco as a distribution and marketing arm to get the Ohio manufacturing facility into profitability.

Although the technology transfer agreement between Sun Pharma and Caraco has ended, Sun Pharma has a strong vested interest, 76% equity interest, in Caraco. Also the recent agreements between Sun Pharma and Caraco show that Caraco has plenty to gain from the relationship with Sun Pharma. Sun Pharma’s founder and CEO, Dilip Sanghvi, serves on the Board of Caraco, along with 3 other Sun Pharma executives on the Board.  

Caraco’s Business

Caraco’s turnaround has been spectacular for Sun Pharma and Caraco. From the 1997, near death status, Caraco has become a growth machine. It has gone from practically zero ANDAs awaiting approval in 1997 to 23 ANDAs awaiting approval as of October 2008. It has gone from an accumulated $28M in NOLs, to a net income of over $35M (this doesn’t include $12M in non-cash R&D expense due to the technology transfer agreement) in FY 2008. Also the company has gone from buried in debt and no cash, to a balance sheet with zero debt and over $30M in cash.

Management expects sales to grow by 25% in FY 2009. Compared to the 6-months of FY 09 to FY 08, Caraco has grown sales by over 70%.

Caraco continues to expand its product offerings and ANDAs awaiting approval. The company currently has 23 ANDAs awaiting approval for 19 products. Also, with its distribution agreement with Sun Pharma the company has access to additional products awaiting ANDA approval. Combines Caraco and Sun Pharma, there are 95 ANDA awaiting approvals. So the growth pipeline looks extremely good.

Caraco also continues to expand its manufacturing facilities. At the start of 2007, Caraco owned 114,000 sq ft and leased 67,000 sq ft of manufacturing facilities. In 2008, Caraco acquired 135,000 sq ft of distribution warehouse. Also, the company started a building an expansion facility of 140,000 sq ft in Detroit. Once the expansion facility is ready to go, the company plans to double its headcount. The cost of new facility is estimated at $14.5. Caraco secured the deal under very favorable terms with the city of Detroit and the state of Michigan where these local governments give the company $14 million of tax abatements over the next 12 years. Also, the State of Michigan will provide a comprehensive job training and retention program, which the State values at $13M. The training program will be focused on developing coursework at community colleges for pharmaceutical manufacturing. This will decrease Caraco’s operating costs and should make its employees more productive.

Competition

Caraco is like a hobbit compared to its competitors. Although it might be small in size, you will be amazed by how big its feet are.

The above table has mixed results, so let’s look at it carefully.

Caraco has over 20% of market cap in cash and zero debt. Compared to its peers, it has the most amount of cash compared to market cap and its zero debt allows it to operate without needing to access the capital markets. With an EPS of $1 and a stock price of $4.15, you get an earnings yield of almost 25% for a company that is growing over 25%.

The SG&A expense shows that Caraco has the lowest SG&A expense compared to its peers. One of the strengths of Caraco, and Sun Pharma, is that their management is extremely efficient in running a low-cost operation compared to peers in the industy. Sales of the company have increased from 64M in 2005 to 350M in 2008, in the meanwhile, SG&A has increased from 5.8M in 2005 to 14.3M in 2008.

Caraco’s pre-tax profit margin is low compared to its peers. The main reason for this is the distribution and marketing agreements that state 8% margins on Sun Pharma Para IV drugs and 10% margins on Sun Pharma ANDA drugs. Since Sun Pharma is taking all the risk in R&D, filing, waiting for approval, and legal costs the margins that Caraco more than  compensated for the risk it is taking, which is zero. Caraco gains from flow-thru of the additional stream of sales dropping to the bottom line.

Let’s take a look at what happened in the past two quarterly reports.

We know that the distribution deal with Sun Pharma has a 8-10% gross margin. Based on the information above, if we assume that all the sales increase is coming from the sales via the distribution agreement we can see that most of the sales is dropping to pre-tax income. I’ve taken an average 9% gross margin to apply to the additional sales. In Q2 of 2008, the company had increased sales of 81M, compared to last year. Taking 9% of the increase we get 7.29M. The company’s Pre-tax Income increased by 8M in Q2 of 2008, so most of the gross profit dropped to the bottom line.

The company’s low-cost advantage and distribution agreement with Sun Pharma will allow the company’s bottom line to grow at a healthy pace.

The Financials

The Income Statement

Caraco’s management has been conservative in making projections and has delivered beyond expectations.

In the 2006 annual report:
“We believe that we will continue to achieve 25% to 30% revenue growth during Fiscal 2007 over Fiscal 2006.”

Net Sales for 2006: 82M
Net Sales for 2007: 117M
Increase in Sales: 42%

In the press release for 2007 annual reports:

“Based on current trends and future realizations, we believe we will achieve a 30% growth in sales for fiscal year 2008, compared to fiscal year 2007”

Net Sales for 2007: 117M
Net Sales for 2008: 350M
Increase in Sales: 200%

In the 2008 annual report:

“Based on our own development pipeline and the current agreements we have with Sun Pharma along with other third party developers we believe we will achieve 25% growth in sales for Fiscal 2009, compared to Fiscal 2008.”

Sales for first 6 months of 2008: 76M
Sales for first 6 months of 2009: 230M
Increase in Sales: 202%

The company’s sales growth has been accelerating and future product pipeline is extremely strong. Between Sun Pharma and Caraco, there are 95 ANDAs awaiting approval. Caraco currently has 23 ANDAs awaiting approval.

The Balance Sheet

Caraco’s balance sheet has been free of long-term debt since 2003. The company currently has 33M in cash. Caraco has mentioned that it plans to use its strong balance sheet to make acquisitions. Given the tightening of the credit markets, there will be opportunities for Caraco to acquire companies that are struggling due to the credit crisis.

The company’s net book value is 161M. So you are buying the company for less than book value.

The Cash Flow Statement

For the 12 months trailing, Caraco had 40M in net profit. The CapEx for the past 12 months has been 18M, but in the last 6 months it has been 8M and 6M per quarter. Caraco is currently in the process of doubling its manufacturing capacity. So the CapEx are not normally expected expenditures. The CapEx for FY08 was 5M, FY07 was 6M, FY06 was 3.6M. So a FCF for the past 12 months is 22M (40M – 18M).

The company expects the expansion development to be completed at end of 2008. I expect the CapEx to get back to normal in 2009, expecting around 1-1.5M per quarter. If we apply the normal expected CapEx to the past 12 month’s CF from Operations (Caraco has negligible depreciation/amortization), we get a FCF of 34M (40M – 6M).


Valuation

I believe that currently Caraco sells at an extreme discount compared to its peers and valuations used in recent mergers and acquisitions.

Caraco is attractive given the low P/E, Price/CF, and Price/Sales multiples. A Price/CF multiple of less than 6.6x for a company that is growing at 25%. The adjusted CF removes the non-cash R&D expense that the company had accounted for as part of the technology transfer agreement (Caraco transferred 544,000 shares to Sun Pharma for each ANDA that Sun Pharma transferred to Caraco). At adjusted Price/CF, you have the company selling at 40% discount to its peers.

In FY 08, the company had earnings of 35M. If you assume normalize CapEx of 5-6M, you get a company that is selling at 4.8x CF, and at 3.6x if you remove the cash. If you assume atleast an 8x of earnings, you are getting the company for half the price. 

The generics industry is expected to grow in double-digits until 2011. The company has stated a 25% growth for current year. Let’s be conservative about the FY 2010 and 2011 growth rate and expect 15% growth. We assume that all sales increase have a 9% gross margin, and that 4% (of sales increase) hits the bottom line.

The above projections use a fairly conservative growth of 15%. The company has been growing sales over 28% for the past 3 years, so 15% is a very conservative projection. I use the 25% growth estimate for FY2009, although the company is currently on a pace to grow much faster. Also, given the favorable conditions for the generic industry, I think the company can easily grow around 15% in 2010 and beyond.

For a terminal value, I expect the company to make a net income of 44M and growing in double-digits, I use a 12x of 44M. That gives a value of 529M and with 114M in cash, the company should be worth 643M. At the current price of 145M, it seems the market is throwing a pitch right in the middle of the plate.


Conclusion

With a large number of products in pipeline, a strong backing from a large pharma, zero debt, and solid balance sheet, Caraco is a fast growing company with large potential trading at an extremely cheap price. Caraco has the tools and the backing to compete larger firms on a large scale.

At current earnings, you are getting a high double-digit growth company, with a strong backing from a large pharma company, with over 20% of market cap in cash, and no debt for about 3x of current earnings (adjusted for cash).

Further Reading:

Story on Sun Pharma’s acquisition strategies and future acquisitions:
http://www.ibef.org/artdisplay.aspx?cat_id=24&art_id=9572

Another analysis of Caraco:
http://seekingalpha.com/article/61962-caraco-pharmaceutical-laboratories-fast-grower

Investor Presentations:
http://phx.corporate-ir.net/phoenix.zhtml?c=98920&p=irol-presentations

Story of Dilip Sanghvi (Buffettesque CEO):
http://economictimes.indiatimes.com/News/News_By_Industry/Healthcare__Biotech/Pharmaceuticals/Sun_never_sets_for_Dilip_Shanghvi/articleshow/3725087.cms

Catalyst