Warner Chilcott Ltd WCRX
April 04, 2011 - 10:30pm EST by
elke528
2011 2012
Price: 23.92 EPS $3.31 $3.62
Shares Out. (in M): 256 P/E 7.2x 6.6x
Market Cap (in $M): 6,124 P/FCF 13.9% 14.5%
Net Debt (in $M): 4,260 EBIT 1,430 1,272
TEV ($): 9,982 TEV/EBIT 7.0x 7.9x

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Description

Warner Chilcott is a specialty pharmaceutical company that focuses on the ob/gyn, gastrointenstinal, dermatology, and urology segments.  Their sales strategy revolves around focusing a salesforce intensely on medical specialties with relatively few physicians.  Their product strategy includes meaningful improvements on existing products in order to extend their patent life.  WCRX manufactures product primarily in Puerto Rico, where they enjoy a 2% tax rate through 2024.  WCRX was taken private (from the London Stock Exchange) in 2004 by the private equity consortium of Thomas Lee, Bain Capital, DLJ, and JPM (now CCMP), and went public again in late 2006 on Nasdaq.  In late 2009, WCRX acquired P&G Pharmaceuticals (PGP) which more than doubled the size of the company.  WCRX is based in Ireland but senior management runs the business out of New Jersey. 
 
Valuation Summary:  
Even assuming a disappointing ramp for their three new products and no value for their pipeline, the current price is roughly equal to intrinsic value.  If the new products ramp up to a realistic level based on historic patterns of existing drugs, the stock is worth at least 70% more.  If new products ramp up better-than-expected, the stock is worth ~100% more.  To summarize, this analysis implies zero downside from the existing products with no pipeline success and 155% upside with an upside case on new product launches including the pipeline.  This analysis does not include any benefits from additional accretive acquisitions given their highly advantageous tax structure.  Given management's track record, additional deals and pipeline successes are likely. 
 
Some Industry Background:  In my write-up, I refer to a number of generic drug challenges to WCRX brands, which are normal for the industry.  These are called Paragraph IV Challenges, and there is a complicated set of protocols that govern how generics can enter a market ahead of a brand's loss of patent protection.  For a little background on this, see http://www.paragraphfour.com/explained.html or Ronny Gal from Bernstein has done a good job of describing the process in prior years. 
 

Why does this opportunity exist?
  • Industry subsegment is out of favor:  Specialty pharma companies as a whole are trading at low multiples, primarily because specialty pharma companies historically have had significant exposure to important drugs' patent cliffs.  In addition, the FDA has been very difficult in recent years, so the drug approval process has gotten longer and more expensive.
  • New drug launches cause uncertainty:  Investors are waiting to see how WCRX's two brand new drug launches proceed in 2011.
  • It's confusing:  WCRX was a moving target in 2010.  They integrated the PGP acquisition, divested two drugs, purchased another, and did a large dividend recap.  As a result, WCRX numbers are confusing, and there are many non-recurring items that need to be adjusted for.
  • Modest leverage, but a lot among its peers:  Unlike most specialty pharma companies, WCRX has debt (though only 6.3x FCF) as a result of a levered recap.  I believe that many sell-side pharma analysts are used to dealing with prescription trends and clinical studies, but not levered balance sheets.  In analyzing WCRX models, I noticed that many analysts could not even get the WCRX interest expense right (a clear sign of not understanding their debt load).
  • A private equity overhang continues here, since Thomas Lee, Bain, and CCMP still own about 30% of the shares.  The private equity investors and about half the management team just sold about 25% of their shares in a secondary offering which was just completed (the other half of the management team, including the CEO, did not sell at all in this offering).  The secondary offering overshadowed a recent accretive debt refinancing in which the management team reiterated revenue guidance and raised EPS by $0.15.

Investment Thesis:

  • WCRX's product portfolio has strong market positions, IP protection, and a gameplan for extending those products' lives.
    • Actonel (35% of run-rate revenues; acquired from P&G in 2009):
      • Background:  Actonel is a bisphosphonate for osteoporosis, which has had signficant generic competition since 2008 from generic Fosamax.  Currently, Actonel has about 15% market share of bisphosphonates -- the largest of all the branded drugs, though the category as a whole has been declining as a result of a push towards the generics and some concerns about bisphosphonates as a whole.
      • WCRX Strategy:  WCRX's replacement product is Atelvia, which launched in January 2011 in the U.S.  Other bisphosphonates cannot be taken with food or drink, but Atelvia has an extended release feature, so it can be taken with food.  A recent JP Morgan survey of bisphosphonate-prescribing physicians revealed that they believe that only 56% of patients follow the food/drink restrictions.  As a result, doctors typically do not really know who is benefiting from the drug or not -- and remember that this is largely a drug largely for elderly women, who are typically on multiple pills, some of which need to be taken with food.
      • Key Question:  How quickly can Atelvia replace Actonel and help forestall the impact of generics?  Through mid-March, Atelvia had achieved 10.2% market share of the Actonel/Atelvia franchise.  In a Merrill Lynch survey of 75 physicians who prescribe bisphosphonates, 41% of physicians said that Atelvia would replace most of the Actonel weekly prescriptions and 15% said that it would replace the Actonel monthly prescription.  In the JPM survey, respondents estimated that for new patients, "they would start an average of 37% on Atelvia."
      • IP Notes (Europe):  Actonel is going generic in Europe in Q1 2011 -- they expect a $300m decline, but steadily over the course of the year -- not like in the U.S. due to different generic/brand dynamics.  This has already been incorporated in WCRX 2011 guidance.
      • IP Notes (U.S.):  Teva challenged the Actonel patent and lost, which indicates that this is a difficult drug to replicate (the generic version is of Fosamax, not Actonel, but both are bisphosphonates).  WCRX's patent for Atelvia lasts until 2023.
    • Asacol (25% of run-rate revenues; acquired from P&G in 2009):
      • Background:  Asacol is a drug for ulcerative colitis, whose symptoms include abdominal pain, diarrhea, rectal pain, and fever.  Once patients become stable on a drug, they are very reluctant to switch, which helps explain Asacol's 47% market share for this condition.
      • WCRX Strategy:  WCRX is extending Asacol's life by selling Asacol HD, a 800mg dose (vs. 400mg for Asacol).  Asacol HD was launched in June 2009, and represents ~20% of the Asacol franchise prescriptions, but keep in mind that the penetration curve here is much slower due to the slower switching dynamics for this drug.
      • IP Notes (U.S.):  Last fall, the FDA came out with draft guidance that a generic competitor would need to conduct pharmacokinetic and dissolution studies to establish bioequivalence.  As a result, neither of the generic companies that claim to have a generic could get their products approved since they do not meet these tests.  Mylan, Teva, and Watson are still figuring out how to go after this, but by that point Asacol HD will be further pentrated.  Asacol's patent lasts to July 2013; Asacol HD patent protection lasts through 2021.
    • Loestrin 24 (12% of run-rate revenues):
      • Background:  Loestrin is a hormonal oral contraceptive with ~10% market share.  WCRX has rapidly grown market share since it was launched in April 2006.  
      • WCRX Strategy:  In January WCRX will launch Lo Loestrin, which will feature the lowest daily dose of estrogen available in the U.S.  This will not replace Loestrin 24; rather the same 220-territory salesforce will offer both contraceptives to Ob/Gyns.
      • IP Notes (U.S.):  There were two challengers for Loestrin 24, but WCRX settled with both of them.  They gave Watson the right to enter 6 months early (in January 2014).  To Lupin they gave the right to the authorized generic for Asacol in 2013.  There are many generic alternatives for oral contraceptives.
    • Doryx (6% of run-rate revenues):
      • Background:  Doryx is an acne medicine.  95% of prescriptions are now in the 150 mg dosage form.  75% of the acne market is generics, but Doryx does not cause stomach pain.  Among branded drugs, Doryx competes with Solodyne (Medicis product), which is priced 2.5x higher.
      • WCRX Strategy:  WCRX is likely working on some line extension here, but has not disclosed details.
      • IP Notes (U.S.):  WCRX could see competition for the 150 mg dosage as early as October 2011, when a 30-month stay on the generic challenger is lifted.  However, WCRX 2011 guidance assumes that no generics are approved and enter during 2011.
    • Estrace Cream (5% of run-rate revenues):
      • Background:  Estrace Cream is a hormone therapy topical drug with 30% market share.  Premrin Cream (a Wyeth product) is the market leader, and WCRX just follows them on price.
      • WCRX Strategy:  WCRX is working on line extensions, but has not disclosed details.
      • IP Notes (U.S.):  Estrace Cream has not had patent protection since 2001.  Generic competitors have difficulty proving bioequivalence for topicals like these.
  • WCRX has successfully executed similar lifecycle management strategies before:
    • In 2006, Loestrin 24 replaced other Loestrin-branded oral contraceptives that were on a typical 21-day hormone/7-day placebo cycle.  Loestrin 24 is taken for 24 days (followed by 6 days of placebo), which results in lighter and shorter periods.  Despite generic competition, Loestrin 24 continues to grow well.
    • Doryx 150 mg was a replacement for the 75 and 100 mg version.  Within a year of its launch, the 150 mg dosage represented 75% of the total Doryx prescriptions.
    • Asacol HD will be replacing Asacol over time for ulcerative colitis.  As shown in the chart, the ramp has been steady and quick, especially for a sticky type of drug.  Currently new patient start penetration is about 40% and total prescriptions are ~20%.
    • To show that their plans continue on track, management recently reiterated 2011 revenue guidance and increased EPS guidance by $0.15 (4%) as a result of a debt refinancing.
  • WCRX has an excellent management team and board that thinks in terms of cash flows - not in terms of drugs.  
    • Roger Boissoneault has led Warner Chilcott since its spin from Warner Lambert in 1997.  He was supposed to spin it out to an investor group and come back to Warner, but he decided to stay and use it as a platform.  It was a hodge-podge of different products and license agreements that were losing money at the spin.  He cleaned it up and in 2000, WCRX got a foothold in ob/gyn products, which is where Roger spent many years at Warner Lambert.
    • Measure and reward salespeople appropriately:  WCRX has specific territories for its salespeople (ob/gyn, GI, derm, urology) rather than team approaches that most other drug companies take.  As a result, the salespeople build better relationships with the physicians (and staffs) and keep the sample closets full.  Meanwhile, management is able to compare salespeople and determine who are the best and worst performers.  Salesperson turnover is 20%/year - mostly from the worst performers being fired or leaving.  The best performers are compensated very well.
    • Spend only what you need on R&D and sales & marketing:  WCRX focuses their marketing on their salesforce and on couponing and loyalty programs for consumers to help them with their co-pays.  Regarding R&D, the CEO says that their R&D budget starts at zero every year - each project needs to justify itself.  Each new drug must also have a pathway for lifecycle extensions as well.
    • Heavy presence of private equity investors on the board likely ensure good capital deployment decisions.
  • Tax structure gives WCRX an advantage in acquiring assets:  With a cash tax rate of 10-11% from their Puerto Rico presence through 2024, every deal that they do should be significantly accretive.
    • For example, Enablex is a drug acquired in September from its partner because of the win-win dynamics of the tax structure.  WCRX had a co-promotion deal with Novartis, which held the IP for Enablex.  Novartis would pay WCRX 44% of net revenues in the U.S. while splitting the costs.  This structure was tax-inefficient, since more profits stayed in the U.S.  In September, WCRX paid Novartis $400m, which was effectively a purchase price of  ~8.1x FCF.
    • The tax rate is the result of (a) WCRX's corporate formation in Ireland; and (b) a deal with the Puerto Rican government to tax profits generated in Puerto Rico at 2% through 2024.  Since the main value of drugs stems from intellectual property (and manufacturing) housed in Puerto Rico, the bulk of the profits can stay inside P.R. and taxed at a very low rate.  The blended tax rate is higher as a result of transfer pricing with U.S. and European subsidiaries for SG&A services.
  • Excellent financial metrics (30% Net Income Margins, 16% Return on Capital) and excellent valuation (6.6x Cash EPS; 14% FCF yield):  There is a large discrepancy on EV/EBITDA and P/E ratios in the table above as a result of amortization of intangibles and the tax rate.   

Valuation:

Valuation largely hinges on how the three new products (Lo Loestrin, Atelvia, and Asacol HD) penetrate their markets prior to the expiration of their predecessor drugs (Loestrin 24, Actonel, and Asacol).  2014 is the key year since Actonel will likely see generic competition by then, Asacol will already have a generic competitor, and Loestrin 24 loses its patent protection in early 2014.  Nonetheless, due to WCRX's tax advantage, low R&D, and efficient operating model, high free cash flows should result in rapid debt reduction and an accompanying decline in interest expense to help accelerate cash EPS.

For brevity and simplicity, I will focus on the discussion of two key questions:  
  1. How much has the new drug penetrated by the time generics enter?
  2. What are the resulting 2014 earnings?
Downside Case:  The key assumptions are that new products achieve pre-genericization market share (vs. its internal predecessor) of:
  • 17% in 2013 for Lo Loestrin (vs. 3% today and 7% new prescriptions after 3 months on the market).  Assumes generic entry in January 2014.  (For example, this would mean that Lo Loestrin would get 17% market share of the combined Lo Loestrin and Loestrin 24 revenues)
  • 25% in 2013 for Atelvia (vs. 4% today and 10% new prescriptions after 3 months on the market).  Assumes generic entry in mid-2014.
  • 21% in 2013 for Asacol HD (vs. 19% today and 20% new prescriptions).  Assumes generic entry in mid-2013.
This Downside Case results in cash EPS of $2.44 in 2014.
 
Base Case:  Key assumptions for market shares (the generic entry assumptions are the same as above):
  • 29% market share for Lo Loestrin in 2013.
  • 51% market share for Atelvia
  • 39% market share for Asacol HD
This Base Case results in cash EPS of $3.24 in 2014.
 
Upside Case:  Key assumptions for market shares (same generic entry assumptions):
  • 33% market share for Lo Loestrin in 2013.
  • 64% market share for Atelvia
  • 48% market share for Asacol HD
This Base Case results in cash EPS of $3.60 in 2014.

Applying a 10x multiple to the Base Case 2014 cash EPS would result in 35% upside on its own, excluding any value from pipeline successes or from the cash that will be generated from 2011-2013.  I estimate that WCRX will generate almost $3 billion of cash flow during that period, or ~$11.50/share (another 47% upside).

So in the Downside Case, applying a 7x multiple results in $17/share plus $11/share of cash generated between 2011 and 2013.  As you can see, the cash-generating capabilities of WCRX provide a significant margin of safety.
 
 
Sources of Additional Upside:
  • Pipeline:  Despite spending a relatively little amount on R&D, WCRX tends to be efficient.  Last year, they actually got three drugs approved, which is a challenge in the current FDA environment.  If they are able to launch per year one $300m new drug or drug extension - like Lo Loestrin or Asacol HD - that can extend the life of their franchises, they will be able to convert WCRX from a relatively stable cash flow machine to a growth vehicle beyond 2014.  Specialty pharmaceutical companies get in trouble when management falls in love with science; WCRX remains very disciplined on its R&D projects.
  • Accretive Acquisitions:  While difficult to model, WCRX's tax structure gives it the ability to acquire certain companies or pharmaceutical products at highly accretive levels.  As a rule of thumb, I estimate that each $100m of acquired revenues adds $0.10 of cash EPS to the stock, without any consideration for what WCRX can do to add value to those products/companies (like they did for the PGP products).  If you would like to see what a significant tax advantage can do for a pharmaceutical company with an acquisition strategy, take a look at Valeant Pharmaceuticals over the past 8 months. 

Risks:
  • If WCRX is not able to successfully convert their older products to the newest generation, they are at greater risk of generic competition in 2014.  But hopefully I have shown that they will still generate significant cash between now and then as well has still have ~$2.24 of Cash EPS after genericization.
  • Tax rate is subject to some risk:  Could Puerto Rico's tax situation be wrapped into some sort of overall U.S. tax overhaul intended to lower overall rates but close loopholes?  This is likely one of the biggest risks, but I have not uncovered any proposals that would threaten the thesis, nor do I think this is likely.
  • Leverage is not excessive, but it's not trivial either:  Given the advantageous tax structure, debt/EBITDA looks very large at 3.6x EBITDA, but debt/FCF is only 6.3x.  Maturities between 2011 and 2014 total $900m, or just about one year's cash flow.
  • New and successful generic challengers, especially for Doryx 150 mg and Estrace Cream.  This is hard to handicap, but these products only represent 11% of revenues.  Estrace Cream, like many topicals, is difficult to replicate for generic companies.
  • Private equity has been in this deal for 6 years now, and they will seek an exit at some point:  Given that they just did a secondary offering, it's not a certainty that they won't exit at these low valuations.  This is the hardest point for me to refute -- other than seeking liquidity in an orderly fashion after 6 years in the deal, why did they just do the secondary?
 

Catalyst

  • Continued ramp of important new products (Lo Loestrin, Atelvia, Asacol HD)
  • Accretive acquisitions in conjunction with their advantageous tax structure
  • Pipeline successes
  • Continued strong free cash flow results in debt reduction and EPS acceleration
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