Saturday, March 17, 2012

Mylan Labs Creates Too Much Uncertainty

Mylan at the Nasdaq

I recently exited a position in Mylan Labs $MYL and, I thought it would be interesting to do some equity research analysis on Mylan and the reasons why I sold.

Sometimes, with an investment, you get a nagging sense of some things that you are not quite comfortable with. When it builds so that your spider senses are tingling, I usually find it is time to sell.

 So what is about Mylan that attracted me to buy and, why did I then sell?

Mylan Attractively Positioned in Generics Market

The market for generics is a no-brainer for future growth. The US has to cutback on its burgeoning healthcare spending and indeed, one of the first things Obama did was take steps to introduce a regulatory pathway for biologic generics. Generics are not only cheaper for the consumer, they also tend to generate more profit for the distributor. Companies like CVS $CVS should see margin expansion by selling more generics. Throw in a substantive number of high profile drugs that will be going off patent in the next few years and, the outlook seems good.

Similarly, Europe has a far lower penetration rate of generics than in the US and, there will be a lot of political pressure to increase this rate in future. Moreover, an ageing population should ensure strong volume growth. In addition, whilst pricing is always an issue with generics companies (pricing declines rapidly once other entrants release copies) it should be noted that producing generics is no easy business.

Producing bio-similars is even harder because of the complicated manufacturing processes involved. The likes of Mylan, Teva, Watson and Sandoz (Novartis) do have a kind of moat.

So, why did I sell?

Herb Greenberg and Mylan

In a CNBC article, Greenberg highlighted a few causes of concern. He cited the recent investor day when Mylan outlined a $6 EPS target for 2018.  He then goes onto to point out that Mylan paid $22m to buy the right to develop Pfizer’s generic version of GlaxoSmitKline’s blockbuster Advair for Asthma and COPD.

Mylan are also getting the right to Pfizer’s dry powder inhaler which they can also use for other products. Mylan then put a contingent consideration of $376.1m on the balance sheet, which Greenberg argues gives them latitude to adjust non-cash earnings, because the consideration involves discretionary assumptions over future royalties, milestones and profit sharing.

Frankly, I think Greenberg’s skepticism is worthy but doesn't entirely hit the salient points. Biotech & Pharma investors know that the value of a company lies in its pipeline. If this program is successful, then Mylan pays the consideration. If it isn’t, Mylan doesn’t. However, the estimation of the risk weighting in the pipeline will change with investors’ perceptions and, with clinical trial, market or regulatory evidence. Investors know this and, I doubt that anyone took Mylan’s 2018 EPS target of $6 with anything other than a pinch of salt.

Mylan investors want to pay the consideration and therefore, they do not want to see earnings adjusted upward by the company reducing the liability. Investing in biotech is not for those who don’t like uncertainty!

Key Takeaway: Where I do agree with Greenberg, is with being dubious over companies talking about EPS numbers in six years time!

Vectura's GyroHaler (source Vectura)

Vectura VR315 Generic Advair?

Vectura is a UK listed pulmonary drug delivery company which is widely believed to be developing a generic version of Advair (Seretide). They have an extensive partnership with Novartis and their generic arm Sandoz. Indeed, Vectura are developing VR315 with Sandoz in Europe and analysts see in being on the market there in 2013-14.  However, in the US, Sandoz returned the rights to Vectura in 2010 and, this should be seen as a warning that the regulatory and competitive environment is likely to be tough in the US.

Vectura has subsequently agreed another partnership with a US pharma co for VR315 in the States but Sandoz really was the ideal partner. Analysts expect a 2015-16 launch but I’ve seen estimations for probability for this as low as 19%

Key Takeaway: Sandoz walked away from generic Advair in the US and, Mylan is talking about the generic as a potential ‘game changer’ for the company and baking that into long term forecasts.

Management Keep Selling Stock

If you are going to talk about $6 in 2018 (which would put the stock on 3.8x earnings) then it is not a good idea to promptly start exercising options and selling stock off. The investor day took place on the 21st February 2012. Following that….

  • 22-24 Feb Wendy Cameron exercises a cumulative 106,875 shares worth of options and then sells 106,875.
  • 23 Feb-13 Mar  Douglas Leech exercises 33,750, sells 33,750
  • 2-15 Mar Robert Coury exercises 231,771 and sells 184,342

Prior to the investor day, 
  •  17 Jan-15 Feb Coury exercised 300,000 and then sold 300,000

Incidentally, all numbers are sourced from Yahoo Finance.

Key Takeaway: Management are exercising options and selling stock.

My Mylan Conclusion

Putting all these things together makes me feel uncomfortable. I like the sector, I like Mylan but biotech investing is already full with uncertainty, it doesn’t need more. It doesn’t need management’s making ambitious projections and, then exercising options and selling stock. As for the pipeline, respiratory is competitive and biogenerics are fraught with ‘known unknowns’.

I am also slightly skeptical with some of the language used to promulgate Mylan’s future success. For example, at the investor day, Mylan’s ability to generate cash was championed and, then the CFO announced that Mylan would ‘generate over $1bn annually and beyond in financial flexibility’.

Everyone else talks about free cash flow generation, so what does ‘financial flexibility’ mean?  Apparently, it means free cash flow plus borrowings. Are we supposed to applaud the fact that Mylan can borrow money?

From the investor day presentation, the mid-point of guidance for 2012 adjusted free cash flow is $600m (flat on 2011) and for a business with an Enterprose Value of $14.67bn this does not make the stock cheap at the current price of $22.89

Moreover, Mylan has refused to reinstate a dividend, despite the management’s confidence in the outlook.

Frankly, there are too many questions here and I decided, perhaps wrongly, to close my position.

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