Monday, October 1, 2012

Perrigo Equity Research

Perrigo $PRGO is one of those stocks that torment investors. The long term outlook and positioning of the company is excellent and its a sector of the economy whose growth prospects are actually bolstered by a slowing economy. Everything looks great and then you look at the evaluation and conclude that it’s expensive, so better wait for it to fall into your value range. It never does.

Instead it goes up and then every time you look at it again, it keeps going up and winking at you saying ‘buy me, buy me, you know you like the story, buy me’. Of course, there is an inevitable downside to this. The evaluation gets ahead of itself and the stock is susceptible to the slightest hiccup and this is exactly what happened recently.

Perrigo Who?

What makes this stock so exciting is that it is a key beneficiary of a combination of an aging demographic, the need to reduce healthcare costs and the drive of stores to increase their in-store and private label sales. Around 80% of Perrigo’s business is in the over-the-counter (OTC), consumer healthcare, and nutritional private label business. In other words, they make the store brand products for pharmacies like Walgreens $WAG and CVS Caremark $CVS and also for the big box retailers like Costco Wholesale $COST, Wal-Mart $WMTor Target $TGT

It is a growth area. For example, CVS Caremark recently stated that it wanted to increase its own brand sales from 17% to 20% in the next few years. Walgreens is similarly inclined to increasing its private label sales. The big advantage of doing this is that it is a win-win situation for the stores and for the consumer. The consumer gets a cheaper version of the drug and the store makes more money (even though the retail price is less) because it has far lower costs. The loser in this is the consumer healthcare company that owns the brand being copied.

Perrigo has four major growth drivers which should help it expand sales. The first is the trend towards retailers rolling out in-store private label brands as outlined above. The second is increasing number of drugs that are shifting from prescription only to OTC. The third is the companies continued release of new products and the fourth is the increasing willingness of consumers to buy private label brands.  These are powerful drivers and they are also correlated with long term healthcare trends. Perrigo’s growth over the last few years has been very strong as a consequence.

So What Went Wrong With the Latest Results?

The price chart tells you all you need to know about the optimism surrounding the company and this was-in no small part- encouraged by internal guidance which was rising through the year. Here is how the company raised guidance sequentially throughout the year.

Perrigo’s EPS numbers were fine but the market was not impressed by the revenue number coming in right at the bottom of the guidance  it gave at the end of last year. Operating cash flow came in near the mid point of guidance too. Having raised guidance across the board throughout 2012, the final numbers came in as a bit of a disappointment. The stock sold off aggressively.

Incidentally, the EPS guidance for 2013 assumes an 8% rise at the mid-point but the 2012 numbers include a tax benefit of 28c. Stripping this out gives a much more impressive underlying growth rate of 14.6% at the mid point.

What’s Wrong With Mid Teens Earnings Growth?

Nothing really, except that the company appears priced for much higher growth. As attractive as the company is I can’t see paying an EV/EBITDA multiple of 16x. No pharmaceutical manufacturer is without risk and Perrigo’s fortunes are also subject to strategic decisions made at the retailers. The mid-point of next years guidance puts it on a forward PE of 20 and from a cash flow basis the stock doesn’t look cheap either. The stock does deserve a premium, but it is very hard to argue that it is good value.

By way of comparison a generics manufacturer like Mylan Labs $MYL trades on an EV/EBITDA multiple of 9.2x and a forward PE of 9.5x while Teva Pharmaceuticals $TEVA trades on multiples of 7.7x and 7.5x respectively. These two have their issues. For example, Teva reduced earnings guidance. With Mylan, I have a certain amount of scepticism over some parts of its growth program. However, valuation still counts in investing as far as I am concerned. Both these stocks are positively exposed to the general idea of a polity and populace trying to reduce health care costs and are probably worth a closer look while waiting for some of the excess optimism to be taken out of Perrigo’s stock price.