Description

Taro Pharmaceutical Industries offers the rare opportunity to buy into a good business, at a great price, alongside a proven management team. The reason this opportunity exists today is a combination of Taro being relegated to the pink sheets and a nasty and disruptive battle for Taro since 2007. Both of these factors are going away paving the way for Taro to eventually receive a fair valuation from Mr. Market.

A good business:

Taro is a leader in the generic pharmaceuticals industry with attractive underlying industry dynamics. The company offers over 200 products to U.S., Canada, and Israel pharmaceutical markets with both proprietary and branded products.

This shareholder presentation from the former management team does a good job of outlining the business. 

http://sec.gov/Archives/edgar/data/906338/000134100409001901/ppt.htm

My understanding is that one of the reasons why Taro has been able to generate 55%+ gross margins is because they specialize in many hard to make generic drugs which limits competition. For example, creams and ointments, which constitute a large percentage of Taro's existing portfolio, are hard to get approved because they can't be measured in the bloodstream. Taro has market share of greater than 50% in many of its niche therapeutic categories. I thought this recent interview of Dilip Shanghvi, Taro's Chairman of the Board (more on him later) provides some insight into why Sun was interested in acquiring over 50% of Taro.

He says that in the fast growing US generic space, there are three large companies: Teva, Sandoz (the generic arm of Novartis) and Mylan. Then there is the mid-sized Watson and then the field is open with a clutch of sub $1 billion companies, mostly from India. In the next five years, several blockbuster drugs will come off the patent list to be legally replicated by firms like Sun. Shanghvi says, "There is enough head room to grow, especially as we are focused in the niche therapeutic segments." 

Additionally, Dilip said this on the recent Nov 1^st Sun conference call:

Taro brings to the table a large U.S. generic business with 150 ANDAs and manufacturing sites in Israel and Canada. Of course, the big challenge of helping Taro improve its performance is still ahead and remains to be executed. This is being given the high priority that it deserves. While we are confident that performance for Taro will improve, it's likely that things will change only gradually.

Great price: The Numbers:

Below are the numbers for Taro since 2000.

I should note that 2008, 2009, and 2010 are not audited. The current CFO told me that he expects to be current by the end of this year and they intend to relist on the Nasdaq subsequently thereafter (note that if they had no intention of relisting on the Nasdaq, this would have been an easy pass given what it implies).  

I would like to highlight a couple items:

• For those who toss and turn at night about the macro, here is business that has already been stress tested and organically grew the top line right through the "great recession."
• Net debt has been reduced from $216mm in March 2007 to zero today. It is hard to fake cash generation. While the stock price has doubled since Sun first made the offer in 07 to buy the company for $454mm, you are almost at the same EV today because of the cash generation.
• The CFO was unwilling to give me guidance on margins going forward but when you read what Sun has said, it is every intention to raise Taro margins up to Sun's (Taro EBIT margins of 23% versus 31% for Sun's in the most recent quarter).
• There is no research coverage on Taro but there is ample research on Sun Pharmaceutical (10 billion market cap) that analyzes Taro. This is what UBS has Taro doing the next two years (the CFO said he never spoke with UBS and wasn't aware of the research report). The numbers have not been revised post recent quarter.

                2011       2012

Sales      360         360

NI           70           90

EBITDA 100         121

• Most of the better P&L performance over the next few years I expect to come from cost savings versus top line growth. The biggest item going forward will be legal/audit bill savings which should save the company $10mm a year. The audit bill savings will come after this year (three years of audit costs this year). Additionally, the company shut down their Irish facility which should save them around 800K a month. All together, you have at minimum $15-$20mm of savings.

Great price: Valuation:

Taro is trading at 5x EV/EBIT run rate and 7x run rate earnings without baking in any cost savings assumptions happening. It is interesting to note that Sun is trading at almost 4x the price of Taro (20x EV/EBIT 2011E and 22x EPS 2011E). 

Proven Management:

It took over 28 months for Sun to finally get control of Taro and I think minority shareholders are much better off because of it. I have posted a timeline below of the saga and I think this presentation from Sun is worth viewing as well.

Sun Presentation:

http://idc.api.edgar-online.com/efx_dll/edgarpro.dll?FetchFilingConvPDF1?SessionID=Or9cHtbPJO7ocSS&ID=6942362

The "paper trail" of Sun versus Taro is black and white:

• Sun has a 10 year track record of acquiring 14 high potential yet under performing businesses and turning them around.

• The turnaround that is most visible is Caraco (ticker: CPD), which despite lighting striking and the FDA basically halting the entire business, has compounded shareholders money at over 20% (although terrible the past 5 years) since Taro took a majority stake in 1997. Besides growing the top line from $1mm to $300mm, Sun was able to take EBITDA margins at Caraco close to Sun's own 30%+ before the FDA issues led to a stoppage of production. It is worth noting that the company does investor presentations and writes annual reports despite Sun having control of the company.

• Rs 1,000 Invested in the 1994 IPO of Sun is currently worth more than Rs. 155,000! Dipid understands how to grow shareholder value over time (and has the high priced currency to do it).
• Management at Taro had basically brought them to the edge of bankruptcy by spending more than $200mm in capex between 2003-2006 and needed a cash infusion from Sun to bail them out of a possible credit default. Since Sun's involvement, Taro has witnessed a substantial turnaround in the business. The CFO has said that they expect capex between $5-$10mm going forward.
• I thought it was interesting that Templeton ended up seeing the light and siding with Sun in the battle. Here is what Templeton said publicly on December 11^th, 2009 and which Sun supported:

"The current board and management of the company have proven unwilling or unable to run the company in the interest of its shareholders; and, in our view, they do not deserve the support of Taro's shareholders. We urge shareholders to block the proposed indemnification requested by Taro's Chairman and to demand the disclosure of audited financial accounts. All shareholders should push for full transparency, re-listing of Taro's shares on NASDAQ, and the the introduction of a new, professional board that acts in the interest of all shareholders and releases audited accounts. "

• I'm waiting for confirmation from the company, but from the most recent filing it looks like Templeton just sold all their shares at 16 back to the company. This is a 40% premium to the stock price before recent earnings were released (which is the same time this filing came out). I'm surprised they sold at this price but there could be non-Taro specific reasons why they sold. I look at this action as a slight negative but you could spin it either way.

Articles of interest:

•1)       Dilip Shanghvi: The Contrarian Forbes:

http://business.in.com/article/india-rich-list-10/dilip-shanghvi-the-contrarian/18382/0

•2)       Sun Investor Presentation

http://www.sunpharma.com/Prsentation.do

•3)       Sell side report coverage: JM financial, UBS, IIFL, RBS, Morgan Stanley etc.

•4)       Timeline:

Dec 06 - Taro delisted from Nasdaq.

May -07 - Initial investment by Sun Pharma, purchases 6.8mn shares at $6.00 through new issue of shares by Taro along with 3-year warrant to purchase additional shares at $6.00.  Option agreement signed with Dr. Barrie Levitt, Dr. Daniel Moros, Ms. Tal Levitt, Dr. Jacob Levitt and Taro Development Corporation. The agreement granted the option to acquire certain ordinary shares owned by Dr. Barrie Levitt, Dr. Moros,Ms. Levitt, and TDC for $7.75 per share, as well as all of the founders' shares, which represent one third of the voting power of all of the Company's shares, for no consideration on the condition that Sun will commence a tender offer for the ordinary shares from other shareholders at $7.75.

19-Feb-08 Sun purchases 3.7mn shares from Brandes

28-May-08 Taro terminates the merger agreement and sues Sun in a Tel-Aviv district court requesting to initiate a special tender offer

25-Jun-08 Sun sends notice to exercise the option agreement to purchase the promoters shareholding in Taro

30-Jun-08 Sun commences the tender offer at $7.75 for ordinary shareholders

26-Aug-08 The Israel district court rules in favour of Sun - rejecting the demand for a special tender offer

28-Aug-08 Taro files an appeal in the Israel supreme court and requests a temporary injunction from Sun acquiring shares through the tender offer

1-Sep-08 Israel supreme court grants a temporary injunction ordering Sun to refrain from purchasing Taro shares until a decision is Ruled

30-Nov-08 Sun notifies Taro to exercise the warrant to purchase an additional 3.78mn share at $6.00. Taro refuses to issue shares since it would be in violation of the supreme court injunction

3-Feb-10 Israel supreme court orders current status to be maintained till a final decision

27-May-10 Guggenheim securities (advisor to Taro) offer to buy Sun's equity stake for $15 per share. Sun rejects the offer.

15-Jul-10 US District court rules in favor of Sun - rejects Taro's demand to block Sun's tender offer

7-Sep-10 Israel Supreme court rules in Sun's favor that a special tender offer is not required - lifts injunction to permit the closing of tender offer

21-Sep-10 Sun acquires controlling stake in Taro with 48.7% equity stake and 65.8% voting rights

Source: Company, JM Financial

Risks:

• 1) Audited numbers come back very different than numbers that they provided
• 2) Sun hurts minority shareholders of Taro to the benefit of Sun (using Taro sales force to sell Sun products without just compensation etc.). Note that Sun is incorporating Taro's financials so the idea that they would want to make the numbers look bad so that they could buy out the rest of minority shareholders would cause Sun numbers to look bad as well (they incorporated 10 days of Taro already in latest Nov 1^st results). Also, Sun wants to do more acquisitions in the future and having a good reputation by the marketplace should be #1 priority. They also just got out of a nasty battle where they held themselves out to be good actors. It is hard to believe that now that they have control, they will behave inconsistent with their espoused values.
• 3) I don't have a relationship with the Chairman and have yet to speak with him. He is the one driving everything here.

Catalyst

Catalysts:

• 1) Audit completed and relisted on exchange
• 2) Investor awareness
• 3) Sun turnaround continues
• 4) Time