Description

I believe an investment in TARO offers a catalyst with a shareholder vote later this month and upside of 114% if it were to trade at similar multiples of its public peers and 59% if it gets purchased by another generic drug manufacturer at the median transaction multiple of historical comparable generic drug merger and acquisition (M&A) deals. 

TARO Pharmaceutical Industries (TARO) is a generic drug manufacturer based out of Israel with its functional headquarters in the United States.  It has been the subject of two takeover offers from its 71% parent, Sun Pharmaceuticals “SUN”, which attempted to buy-out Taro minority shareholders at valuations that I and other shareholders viewed as extremely inadequate.  Today, TARO trades at approximately a 193% premium to Sun’s August 2012 offer which was abandoned in February 2013.  Taro’s share price was at $112.84 as of 3/5/2014.

In the near-term, there is a likely catalyst on the horizon.  On March 27^th, 2014, there is an extraordinary shareholders meeting to vote on independent directors of the board, where the minority shareholders can vote on two seats that represent them on the board.  This event creates an opportunity for truly independent board members to be put in place, nominated by activist investor BlueMountain, to help get shareholders fair value for their investment, instead of being squeezed out by the majority shareholder, SUN.  Also, since TARO is an Israeli company, minority shareholders have rights afforded to them that prevent any acquisition without approval by a majority of the minority.

You can read BlueMountain’s press release from January 31, 2014, here:
http://finance.yahoo.com/news/bluemountain-capital-management-iszo-capital-000400436.ht                               ml

TARO manufactures over 200 different prescription and over-the-counter products in facilities located in the US, Canada and Israel.  Its main area of expertise and specialization is in dermatological creams, ointments and gels.  This area of the generic pharmaceutical industry has characteristics that make it highly profitable for the companies in this niche.  Most dermatological prescriptions have relatively low prescription counts and require more sophisticated production methods than normal generic pill based drug manufacturing.  Also, for creams and ointments to receive FDA approval, the manufacturers need to perform trials to show the FDA the generic formulation’s effectiveness and safety, which is another hurdle that normal pill generics do not have to complete.  This creates a large barrier to entry as it is quite expensive to build a manufacturing facility and gain FDA approvals for new generic creams and ointments.  This has led to an oligopolistic (2 to 4 competitors per drug) industry structure with high margins.

Another interesting thing to consider about the dermatological creams industry is that most of the diseases are not life-threatening and usually symptoms are treated and not cured, thus creating a naturally recurring revenue business.  Since such treatments are a good enough solution, there has not been much in terms of advancement in this area of drugs compared to other areas such as cancer, aids, heart disease and diabetes.  There is not the same type of risk for technological obsolescence in dermatological creams like there is with those other types of drugs.

You can read my previous write-up on Taro from September 2011, here:
http://www.valueinvestorsclub.com/value2/Idea/ViewIdea/56987

So What Is Taro worth?

One commonly used method to value companies is by looking at where other comparable companies trade in the public markets.  For comparable companies, we used TEVA, MYL, PRGO and ACT.  TEVA, MYL and ACT are generic pharmaceutical companies which primarily sell products in pill and tablet form, as well as some dermatological drugs, and generate most of their revenue from North America.  PRGO sells many OTC products as well as generic pharmaceuticals, which also include dermatological generics. Below is a table showing these companies and their Enterprise Value “EV” to trailing twelve months “TTM” EBITDA multiples:

Sun, which has approximately 40% of its EBITDA being contributed by Taro, trades at 18.7 times TTM EBITDA according to Bloomberg.  As a matter of fact, Taro provides nearly all of the cash that Sun shows on its balance sheet, after accounting for the $550m settlement Sun has to pay.  Assuming Taro trades at the average of the group’s EV to TTM EBITDA multiple, the stock would trade at $241.83.  Based off of stable margins and sales growth of approximately 12% in CY 2014, our valuations for Taro are in the table below:

Based on these projections we would value Taro as a stand-alone public company based on CY 2013 results at $241.83 per share and $280.16 by the end of December, 2014 based upon 12% sales growth (they grew sales 13% in calendar 2013, however that included a material net write-off on revenue which they said would be gained in future periods).

The other method to value Taro would be to estimate its worth to an industry buyer.  Recently there have been two acquisitions of generic pharmaceutical companies that should be noted.

The first acquisition of note was in February 2013 when Mylan (MYL) purchased Agila Specialties from Strides Acrolab.  Mylan paid $1.6 billion in cash plus another $250 million in potential payments.  According to public sources, Agila recorded 2012 earnings before interest taxes depreciation and amortization (EBITDA) of $86 million.  Based on the $1.6 billion paid and Agila’s 2012 EBITDA, Mylan paid an 18.6 times TTM EBITDA multiple for Agila.  If I include the additional $250 million in potential payments, the total EBITDA multiple comes out to 21.5 times.  Agila is a generic pharmaceutical company that predominantly produces injectable drugs.  Injectable generic drugs are similar to Taro’s topical drugs in that they are more difficult to manufacture than pill based generic counterparts.  

The second acquisition of note was made by Sun, Taro’s 71% parent. In November of 2012, Sun purchased the dermatological company DUSA Pharmaceuticals (DUSA) for an enterprise value of $168 million, which based off of DUSA’s 12-month EBITDA ending in September 2012 of $7.2 million, comes out to a 23.3 times EV to EBITDA multiple. 

Both of these offers help to confirm that non-pill based generic drug manufacturers sell to industry acquirers for high EBITDA multiples when they have businesses with strong cash flows and limited competition.  As a reminder, Sun’s offer for Taro in April 2011 was for 7.2 times TTM EBITDA.  Sun’s second offer for Taro in August 2012 was for 4.8 times TTM EBITDA.  These offers are clearly well below other M&A transactions in the space, including Sun’s recent acquisition of DUSA.  Sun’s original acquisition of Taro in 2007 was purchased at a multiple of 17.1 times TTM EBITDA. 

If we use historical acquisition multiples to value Taro to a potential acquirer, we can use this list of comparable deals. 

It is important to consider that the two transactions in this list with the lowest multiples, PRX and Foguera, were much lower than the others for special reasons.  First, PRX was primarily a generic pill pharmaceutical manufacturer which has a very competitive environment and differs from companies like Taro as I have previously mentioned. Foguera, while similar to Taro in that they manufactured generic skin care medicine, was different because a very large portion of Foguera’s business was contract manufacturing, which is a low margin business.

Using a median multiple of 15.6 times EBITDA, we get the following values for Taro:

The table shows that Taro could be sold for $178.88 per share currently and $208.64 per share in one year to an industry buyer.  The conservative multiple I chose above is in the lower end of the multiple range of transactions, however I believe that Taro deserves a higher multiple, of approximately 20 times since as mentioned before, I feel that the segment of drugs that Taro deals with has strong barriers to entry compared to other segments.  The market would seem to agree, since the comparable companies trade at such high multiples.  Due to consolidation in the industry, companies like Taro are becoming scarce and have even become targets of branded pharmaceutical companies.

Going forward I think that the minority has a strong possibility of winning board representation through BlueMountain’s nominees during the March 27^th vote.  In December, Taro made a tender offer and acquired an additional 4.4% of the minority shares.  I believe this helps to make the minority shareholder base stronger, as the weaker shareholders decided to participate in the tender.

Catalyst