Monday, March 30, 2009

The Biotech M&A Pipeline

The $46.8 billion Roche/Genentech merger is hailed as a sign of biotech's maturity--two substantial companies joining forces. But a closer look shows that this deal is much like the big pharma mergers which generate short-term balance sheet improvements and massive lay-offs. The major biotechs share big pharma's desperate need to fill their pipelines with someone else's innovations.

Biotech mergers and acquisitions typically occur when the market is in a down cycle and smaller companies are pressed for cash to complete product development and commercialization. Acquirintg companies should make their purchases when their stock price is high eneough to avoid diluting existing shares (and hurting existing shareholders).

In a down cycle, the big biotechs are seen as safe havens and remain pricey. In our opinion, they have a long way to fall before their prices look like bargains.

The way to play biotech now is to head to the 'Tier 3" players. In this group, we like Endo Pharmaceuticals (ENDP) and Techne (TECH). We recently wrote about ENDP and believe the company has a big potential. The Tier 3 players generally have lower valuations, cash, decent partners, experienced management, and a deep pipeline. ENDP is trading close to its 52 week low.

If you want to make it big is biotech, a basket of smaller companies and a lot of patience is the way to go.

Disclosure: At the time of writing, author has no financial interest in any company mentioned here.

Sunday, March 22, 2009

Endo Pharmaceuticals: A Growth Story

Endo Pharmaceuticals Holdings Inc. (ENDP), is a specialty pharmaceutical company. Their particular niche is pain management. The company develops and sells branded and generic pharmaceuticals used primarily to treat and manage pain. According to the company's profile,

"Endo Pharmaceuticals is a specialty pharmaceutical company engaged in the
research, development, sale and marketing of branded and generic prescription
pharmaceuticals used primarily to treat and manage pain. Its products include
LIDODERM®, a topical patch to relieve the pain of post-herpetic neuralgia;
PERCOCET® and PERCODAN® tablets for the relief of moderate-to-moderately severe pain; FROVA® tablets for the acute treatment of migraine attacks with or without aura in adults; OPANA® tablets for the relief of moderate-to-severe acute pain where the use of an opioid is appropriate; OPANA® ER tablets for the relief of
moderate-to-severe pain in patients requiring continuous, around-the-clock
opioid treatment for an extended period of time; and VOLTAREN® gel, a
nonsteroidal anti-inflammatory drug indicated for the relief of the pain of
osteoarthritis of joints amenable to topical treatment, such as the knees and
those of the hands. VOLTERAN gel has not been evaluated for use on the spine,
hip, or shoulder. The company markets its branded pharmaceutical products to
physicians in pain management, neurology, surgery, oncology, and primary

Recently, the company made the following announcement.

"Endo Pharmaceuticals (Nasdaq: ENDP) today announced the successful
completion of the tender offer by its wholly owned subsidiary, BTB Purchaser
Inc., for all of the outstanding shares of common stock of Indevus
Pharmaceuticals, Inc. (Nasdaq: IDEV). American Stock Transfer & Trust
Company, the depositary for the tender offer, has advised Endo that, as of 5
p.m., New York City time, on March 18, 2009, the expiration of the subsequent
offering period, approximately 70,856,245 shares were validly tendered in the
tender offer, representing approximately 89.155% of Indevus' issued and
outstanding shares. Endo has accepted for payment and promptly paid for all
shares validly tendered during the subsequent offering period."

In another development, ENDP announced the following concerning NEBIDO(S):

"Endo Pharmaceuticals (Nasdaq: ENDP) and its majority-owned subsidiary
Indevus Pharmaceuticals, Inc. (Nasdaq: IDEV) announced today that the U.S. Food
and Drug Administration (FDA) has accepted for review the complete response
submission to the new drug application for NEBIDO(R) (testosterone undecanoate)
intramuscular injection, an investigational testosterone preparation for the
treatment of male hypogonadism. FDA is targeting September 2, 2009 as the action
date for a decision on this application. Endo's president and CEO, David Holveck, stated: "We are pleased with the FDA's action and congratulate the NEBIDO development team on reaching this milestone. We look forward to receiving the FDA's decision on the NEBIDO marketing application in September."

The Balance Sheet

Cash represents about 40% of the company's recent selling price. ROIC is 16.66% and tangible equity to capital is 72%. P/TBV is about 2.74. The company carries about $413.5 million in goodwill and intangibles on its balance sheet and about $442.4 million in long term liabilities.

TTM ROA is about 14.31% compared with a five year average of 14.36%. TTM ROE is 21.63% which is in line with the five year average of 20.78%.

The company is profitable, reporting FY 08 EPS at $2.12. Consensus estimates for FY 09 and FY 10 are $2.53 and $2.81, respectively. Standard & Poor's provides estimates of $2.75 for FY 09 and $2.94 in FY 10. The trailing P/E is 7.8X while the forward looking P/E is 6.64X and 5.8X.

Price to Sales (TTM) is 1.55X and 1.36X estimated FY 09 sales of $$1,432.29 and 1.25X FY 10 sales of $1,562.54. The company is selling at 7.9X free cash flow (TTM), 5.6X our estimated free cash flow of $2.99 FY 09 and 5.16X our estimate of $3.25 for FY 10.


We are putting a fair market value on ENDP of $30 by the end of FY 10. This translates to a P/FCF multiple of 9.23X; P/E of 10.2 and a PSR of 2.24X.

Disclosure: Author holds no position in ENDP.

Sunday, March 15, 2009

Hard Driving Western Digital

Western Digital Corporation “designs, develops, manufactures and sells hard drives. It sells its products worldwide to original equipment manufacturers (OEMs) and original design manufactures (ODMs) for use in computer systems, subsystems or consumer electronics (CE) devices, and to distributors, resellers and retailers. The Company’s hard drives are used in desktop computers, notebook computers and enterprise applications, such as servers, workstations, network attached storage, storage area networks and video surveillance equipment. Additionally, its hard drives are used in CE applications, such as digital video recorders, and satellite and cable set-top boxes. It markets its hard drives under brand names, including WD Caviar, WD Raptor, WD VelociRaptor, WD Scorpio, WD Elements, My Passport, My Book, My DVR Expander and GreenPower. On September 5, 2007, WD, through its indirect wholly owned subsidiary, State M Corporation, completed the acquisition of Komag, Incorporated.”

With a market share of the worldwide hard disk market of 26.9%, WDC is behind the market leader Seagate (31.8%) but ahead of Hitachi (17%) and the newly combined Toshiba/Fujitsu (16%).

JPMorgan projects a 19% decline in hard disk drive revenues worldwide to $26.3 billion as competition drives down prices and the global recession leads to a drop in shipments. Sales will not turn-around until the recession abets.


On a price/earning basis, WDC has a history of selling at a substantial discount to the industry average. The company is currently selling significantly below its 3 year, 5 year and 7 year averages.

Conversely, WDC has historically sold at a premium on a price/book basis. Looking at price to tangible book value, the company is selling at a 1.40 multiple.

As with price/earnings, on a price to cash flow or price to free cash flow basis, current multiples are below historic averages and industry averages. However, we project free cash flow to grow to $4.17 over the next twelve months.

Consensus earnings for FY 09 are projected at $1.66, about 56.7% less than FY 08. For the year ending June 10, earnings will decline further to an estimated $1.53. Similarly, sales will decline from FY 08 levels of $8,074 million to $6,750.19 in FY 09 and $6,461.06 in FY 10.

Western Digital maintains a torrid growth rate across all metrics. Sales remain robust even with the drop in worldwide demand.

We see that WDC is able to control costs. Gross, Operating and Net margins are all above their five year averages which speaks well of management and they are not too far off FY 08 levels. Both ROE and ROA show weakness due to the decline in earnings. However, debt has not grown. Going forward, we expect to see continued pressure on margins.


We think that Western Digital is in a strong position to weather the current storm and emerge stronger than before. They have a broad, well-selling product mix. They have a strong balance sheet with cash representing 36% of the current market price, low debt and solid cash flow. Things will get worse before they get better.

We estimate fair market value to be $44.27 or 10.6X our estimated free cash flow. This multiple is below historic averages and provides a margin of safety. We base our estimate of fair market value on the strength of the balance sheet, very manageable levels of debt, more than adequate cash flow and the potential for WDC to make an acquisition.

Disclosure: Author has no position in any company mentioned.

Sunday, March 8, 2009

ADP: The Single Source Solution

Automatic Data Processing, Inc. (ADP) is the leading business outsourcing provider in the human resources, payroll, tax, pension and benefits administration space. ADP also provides industry-specific solutions to automotive, heavy truck, motorcycle, marine and recreational vehicle dealers. The company operates in three segments: Employer Services, Professional Employer Organization (PEO) and dealer services.

The company is beginning to see the effects of massive layoffs throughout the economy. While they are suffering from fewer payroll transactions and being challenged with customer retention issues which will only accelerate as unemployment ratchets up from 8% to a projected 10% level, we feel these challenges are temporary. When the economy recovers and employment returns to more normal levels, ADP will see sales and earnings growth return to higher levels. While we wait for the economy to turn around, ADP retains some pricing power and is able to increase its pricing.

Dylan Cathers, the analyst at Standard & Poor’s projects FY 09 earnings at $2.41, two cents more than the consensus forecast of $2.39. Cathers also sees sales growth continuing at the 3.5% rate in FY 09.

Historically, ADP has traded at a richer multiple than it does now. Regardless of which metric you favor, the company sells at a premium to its industry.

TTM 1 Year 3 Year 5 Year 7 Year
Price/Earnings 14.30 20.20 23.80 25.40 24.10
Industry P/E 10.10 16.80 22.20 24.20 23.60

Price/Book 3.46 4.04 4.28 4.21 4.20
Industry P/B 0.90 1.80 2.40 2.50 2.30

Price/Sales 1.86 2.51 3.01 3.19 3.16
Industry P/S 0.50 0.90 1.30 1.40 1.20

Price/Cash Flow 9.60 16.60 19.80 20.90 19.60
Industry P/CF 7.40 14.60 17.70 18.50 18.50

Price/FCF 17.40 36.00 31.60 30.70 28.50


The company has a history of consistent growth for sales, earnings and free cash flow.

TTM 3 Year 5 Year
Sales 8.80 12.70 4.20
Gross Income 6.00 11.10 3.70
Net Income 29.30 5.40 3.90
Dividends 22.40 21.70 18.00
Cash Flow 43.80 19.00 4.50
Free Cash Flow 72.10 7.80 2.90


The company has a strong balance sheet with little long term debt even though ADP repurchased 33 million shares in 2008.

Current Jun-08 Jun-07 Jun-06 Jun-05 Jun-04 5 Yr Avg.
Gross Margin (%) 54.70% 55.40% 56.50% 56.50% 57.80% 54.50% 56.14%
Operating Margin (%) 0.20% 20.60% 20.80% 19.90% 20.20% 19.70% 20.24%
Net Margin (%) 16.80% 14.10% 14.60% 22.70% 17.20% 12.90% 16.30%
ROE (%) 29.90% 24.10% 20.40% 26.30% 18.80% 17.30% 21.38%
ROA (%) 5.30% 4.90% 4.20% 5.60% 4.30% 4.60% 4.72%
Current Ratio 1.10 1.10 1.10 2.10 1.70 1.60 1.52
Payout Ratio (%) 41.00% 46.40% 42.50% 26.30% 33.70% 34.20% 36.62%
Liabilities/Assets (%) 85.50% 78.60% 80.70% 78.10% 79.10% 74.30% 78.16%
Asset Turnover (X) 0.30 0.30 0.30 0.20 0.30 0.40 0.30

We see the company as having a strong balance sheet capable of sustaining ADP through the next year or two. ADP’s prospects are bolstered by strong and steady free cash flow and a recurring revenue stream. Competition is stiff in this industry but ADP is the leader and, we expect, will remain so.

Our fair value estimate for ADP is $72.50. This is based on our estimate of free cash flows over the next twelve months of $1.82, the expectation of continued growth in sales and earnings and our assessment of the balance sheet.

Disclosure: At the time of writing, author has no position in ADP.
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