Thursday, February 21, 2013

Perrigo is Still Not Good Value

Perrigo (NASDAQ: PRGO) is a company exposed to some very favorable trends in health care, and I would expect its strong performance to continue. In summary, while I have little doubts over its end markets or its growth, the evaluation looks stretched, and there are some near term risks here. Unfortunately, the defensive growth sector (if such a thing exists) has been bid up by the market, and I think investors should stay disciplined and not overpay. However, if you like a long term growth story than Perrigo could fit the bill.

Will Perrigo Hit its Guidance?

I originally discussed the company in an article linked here; I would advise reading that article for a primer on the company. The key questions remain the same after the latest Q2 numbers.

  • Can it really hit the 12-16% guidance range for 2013 when it has just reported top line growth in H1 at 5.7%? 
  • How much longer can Rx Pharmaceuticals (generic prescription drugs) go on expanding margins when it is such a competitive industry? Gross margins hit 58.1% in Q2 alone.
  • Nutritionals growth and margins guidance was downgraded thanks to retailers being a bit slower in phasing out metal cans in anticipation of the launch of Perrigo’s infant formula. Indeed, this is the second quarter in a row where this has disappointed, yet much optimism is still placed on the product for 2013.

I don’t want to appear overly negative on the stock. On the contrary, I think it is exposed to some great end market themes, and its acquisition strategy into animal health makes perfect sense to me. The Velcera acquisition follows on from Segeant in the autumn and establishes Perrigo as a player in animal health; the idea is to expand sales via the retail channel rather than just the vets. In a sense, this sort of activity apes the other key growth drivers at Perrigo. The company is very good at latching onto trends take advantage of changing health care sales channels.

Perrigo’s Growth Trends

For example, the trend towards store brands (from national brands) continues to accelerate. Indeed, companies like CVS (NYSE: CVS), Walgreen (NYSE: WAG) and Wal-Mart are all keen to expand their store brands.  They make more margin (and profits) from their store brands, although revenues take a hit because the products are cheaper. Both companies see this as a great way to expand profits and engender customer loyalty.

Another key trend is the growing shift from prescription pharmaceuticals to Over The Counter (OTC). Again, the key drivers are the desire of both authorities and consumers to reduce costs and in particular in indications like diabetes. Based on Perrigo’s figures, industry store brand sales were up 9.7% while national brands were down 2.1% in the last 52 weeks.

In addition, alongside all of these trends is a general increase in consumer health care spending, a trend driven by lifestyle changes and an aging demographic. Throw in international expansion and the future looks very bright for Perrigo.

Possible Challenges

I want to go back to the questions I asked earlier and put them in the context of the Q2 numbers and discuss some challenges this year.

The consumer health care sector is firing on all cylinders with sales up 23% in Q2 (if normalized with sales days last year) and operating margins expanded 40bp to 18.3%. Perrigo has been favorably helped by the strong flu season and the production problems for Johnson & Johnson’s (NYSE: JNJ) Tylenol have encouraged Perrigo to try and expand Mucinex sales. Indeed, a full scale OTC launch is planned for March. JNJ has had a number of production issues but plans to get 75% of its brands affected back to the market by the end of 2013. Tylenol is one of them, and the timing of this will affect Perrigo.

Nutritionals sales were down 5% in the quarter, and full year guidance was reduced to 1-5% growth. The story here is all about the infant formula, which is intended to resemble some well known national brands. Wal-Mart and Costco were reported to already be positioning the product next to these brands. A lot is being pinned on this product, but I would be cautious here. People don’t take risks with infant formula, and this is a fiercely competitive segment in the US.

Rx Pharmaceuticals sales (which made up 28% of adjusted gross profits in the quarter) were flat on an adjusted basis, and the company is seeing increased competition in this sector, however operating margins expanded to 45.6% and Perrigo maintained its full year 15-19% growth forecast based on a large product pipeline.

Where Next for Perrigo?

Frankly I think there is better value out there, and if you really want to play some of the growth trends discussed above then Walgreen or CVS arguably offer better value. Perrigo has great long term drivers, but it also has near term questions that still appear challenging. The market liked the Q2 results because revenues came in ahead of expectations, but the stock now trades on 24x earnings and a forward free cash flow yield of 4%.

It’s not cheap, and the market seems to want to give it the benefit of the doubt thanks to its long term potential. Investors could wait until it grows into its evaluation but I’d rather try to pick this up cheaper.

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