Friday, December 14, 2012

Is Perrigo Worth Buying Now?

Perrigo (NASDAQ: PRGO) gave results on a tough day for the market and saw itself marked down nearly five percent.  The is the second quarter in a row where its sales have come in a little light and investors have a right to question whether its forecasts for 12-16% revenue growth for 2013 are likely given that it only reported just over 6% in the current quarter. Moreover there appear to be a few assumptions over its growth prospects which are debatable. Don’t get me wrong, I love this company’s prospects, but I question whether it’s at the right price to pay for the risk.

Perrigo is a manufacturer of over the counter (OTC), consumer healthcare and nutritional private label products. I think this is a strong area of growth due to an ageing demographic

Perrigo’s Q1 Results

Before I get into the detail I want to outline how this company’s guidance has moved around. This is a key point to understand because its earnings are variable due to reliance on approvals and customer adoption of its and rivals’ products.

The first thing to note is that revenue and earnings guidance has been raised, but this is largely due to the Sergeant pet care acquisition which is forecast to add 10c to adjusted EPS.  Another point is that CapEx requirements have been raised due to integrating Sergeant and investing in growth initiatives. All of which is fine, but investors need to look at these results in the context of what Perrigo just reported.

 To understand its revenue and profitability mix, I’ve broken down revenues here.

But a more interesting picture is seen when adjusted operating income is broken down too. The key point here is that Rx Pharmaceutical (generic prescription products) has huge margins and makes up nearly 42% of income.

Indeed reported gross margins for the Rx Pharmaceuticals segment are 53% which compares with Teva’s 52% and is in excess of Watson Pharmaceutical's (NYSE: WPI) 42% and Mylan Lab's (NASDAQ: MYL) 44% respectively. These companies are all aggressively trying to expand their generic offerings and it is hard to see why Perrigo should necessarily have higher margins than them.

Moreover, even though the nutritionals segment only made 6.1% of adjusted operating income there was a reduction of about $5.5 million on a yearly basis due to a combination of issues which I will discuss below.

Key Take Aways and Future Challenges

So in summary the key take ways and questions from these results are

  • Whether the 6.1% sales growth reported in Q1 is going to translate into the 12-16% predicted for 2013
  • Can Perrigo retain such high margins in its Rx segment given increasing competition?
  • Will it be able to deal with the issues in its nutritionals segment?

Perrigo’s argument is that the year will be back-end loaded and that initiatives being taken now will drive growth in future. For example, within nutritionals it is introducing plastic packaging which is intended to look similar to national brands. Indeed part of the nutritionals shortfall this quarter was due to disruption caused by this shift. In addition new products are being launched in an aggressive fashion. Nevertheless the last two quarters sales have disappointed the market and without the acquisitions there has been no upgrade to full year sales forecasts.

Perrigo is also facing headwinds within infant nutrition where price competition has been heating up globally. Mead Johnson recently gave results and said a similar thing about intense price competition in the sector. Similarly vitamins, minerals and supplements (VMS) saw tougher conditions amidst increased competition.

Turning to Rx Pharmaceuticals, margins are high and management cited increasing competition in dermatology. The challenge here will be to continue to engage in new product development and hope that the competition doesn’t encroach on their key revenue generators.

I think there are a lot of assumptions being made here so investors need to price in a margin of safety.

Growth Drivers and Headwinds

Going forward Johnson & Johnson (NYSE: JNJ) is expected to get Tylenol back on the market in early 2013 and this will likely have an effect on consumer health sales. Perrigo can expect to keep some sales, but JNJ is a formidable competitor with deep marketing pockets and it is in need of generating some growth again in its consumer products section.

Another area of growth is likely to be the shift of products from prescription to OTC. Pfizer’s (NYSE: PFE) heartburn treatment Nexium is being eyed, but Pfizer is obviously trying to keep exclusivity. In any case Perrigo received FDA tentative approval for another heartburn treatment (omeprazole and sodium bicarbonate) on Oct 16. Sales of store brand omperazole are already expanding nicely for Perrigo.

In the short term the weak economy continues to put pressure on OTC pharmaceutical sales, but Perrigo has exposure to store brands and the drug stores and retailers are keen to expand sales of these higher margin products.

The Bottom Line

In conclusion, Perrigo does have strong long term prospects but mid-term there are questions over its internal execution and future competitive threats. It has disappointed for two quarters in a row with sales and it is relying on ongoing high margins in its generics segment to counteract current weakness in nutritionals.

Frankly I don’t think the current valuation of 24x current earnings and 18x future earnings is attractive enough to warrant the risk/reward proposition here.  Well worth monitoring, but its hardly cheap right now.

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