Magic Formula Stock Review: Endo Pharmaceuticals (ENDP)
Endo Pharmaceuticals (ENDP) is a specialty drug company, with a focus on a few specific areas, namely pain management, urology, and endocrinology. Pain management is the company's forte, led by Lidoderm, a lidocaine medicated patch that is prescribed for a wide variety of pain-related problems. Lidoderm gained traction after orally ingested pain killers such as Vioxx (MRK) faced well-publicized safety concerns in the mid-2000's. Today, Lidoderm accounts for well over 50% of Endo's total sales, bringing in $763 million dollars last year.
Another 16% of sales is generated by the Opana franchise. Opana is orally ingested and is used to treat severe pain symptoms. It is used much like morphine. The third major drug marketed by Endo is Percocet, the well-known painkiller for less severe pain indications. Percocet accounts for about 9% of Endo's total.
While far and away dominated by its pain franchises, the company in early 2009 purchased Indevus, which specializes in urology (bladder and urinary tract) and endocrinology (endocrine system). Currently, the products here account for a rather small portion of sales, about 4-5%.
Let's look at Endo through the filters of growth potential, competitive position, and financial strength. Growth potential is a negative here. Endo faces a common problem in the branded drug industry - patent expiration and the inevitable generic competition that follows. Both Lidoderm and Opana, collectively almost 70% of revenues, have patent cliffs upcoming. Lidoderm has theoretical patent protection up until 2015, but already faces a patent challenge from Watson Labs (WPI). Opana has seen similar challenges, and its patent protections expire before 2013.
The most likely outcome of these challenges are settlements. For example, Endo recently settled generic challenges to Opana from Teva (TEVA), which allow Endo to continue selling the drug until 2012, longer than would have been possible had they lost the challenge, but also before the patents expire. MagicDiligence expects similar settlements related to Lidoderm. It seems reasonable to assume that generic versions of both Lidoderm patch and Opana will hit the market in the 2012-2013 time frame, meaning that Endo will need to replace 60% or more of their sales in the next 3 years. That certainly does not bode well for long-term growth potential.
How Endo will replace those revenues is still in question. The Indevus purchase gives the company a wider market to address, but those sales will have to ramp up fast. The pipeline has had recent problems. Aveed, a long-acting testosterone injection, and Fortesta (testosterone gel), both acquired in 2009, received FDA inquiry letters last December, which well at best postpone their approval. On the pain side, Endo continues to work its strategy of buying the rights to late-stage drugs that improve on existing treatments. While this strategy usually improves the likelihood of approval and limits R&D spending, it also limits the duration of patent protections.
All told, Endo will likely see solid growth into 2012, at which time generic competition could eat as much as half of current revenues. This uncertainty will keep the valuation high on an earnings yield basis.
The other two factors, competitive position and financial health, are positives. Endo, like all branded pharmaceuticals, enjoys strong regulatory barriers to entry through patent protection. This keeps competitors out for a period of time and allows the firm to charge high prices for their drugs. Another competitive advantage is Endo's large 800-person sales staff that focuses on the niche of pain management. This sales department is considered one of the most productive in the industry, and should be an important factor in quickly growing sales of acquired products.
Financial health is fine. The balance sheet has $734 million in cash vs. $322 million in long-term debt. Operating margins are over 25% and stand to improve as Opana and, to a lesser extent, Lidoderm experience volume gains. Free cash flow is outstanding, averaging almost 30% of sales over the past 5 years. This cash flow will help the company acquire new compounds to plug their upcoming sales gaps.
Right now, Endo trades at a trailing, MFI-adjusted earnings yield of 15%. Against expected 2010 results, that figure is 16.2%. That looks too cheap for the profitability just mentioned. Going through a cash flow analysis, I come up with a fair value between $27-$32, depending on how long they can push back generic competition of Lidoderm, and what kind of replacements they can find. So there appears to be upside from the current price around $24... but not a tremendous amount. Therefore, while MagicDiligence has a positive rating, Endo doesn't quite make Top Buy status. This doesn't assign any value to the potential of a bigger pharma player gobbling up the company, either.
Steve owns no position in any stocks discussed in this article.