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MagicDiligence (< 20)

Warner Chilcott Needs to Grow Up



October 25, 2012 – Comments (0) | RELATED TICKERS: WCRX.DL

Warner Chilcott (WCRX) is a mid-sized specialty pharmaceutical company. The firm's largest product category is in women's healthcare, about 57% of trailing 6 month sales as a group. Within that category, the largest contributor is osteoporosis (weak bone condition) drugs, specifically ACTONEL (22% of sales) and its newer delayed-release formulation, ATELVIA (2.4%).

Oral contraceptives ("OC", or birth control drugs), also categorized within women's healthcare, make up 21% of Warner's sales.LOESTRIN 24 (15.5% of total sales) and its replacement, LO LOESTRIN (4.7%) are the two primary marketed drugs here.

The final women's health product category is hormone therapy. ESTRACE cream (7.4%), the main contributor in this category, is a topical treatment for vulvar atrophy.

Warner-Chilcott's next largest product category is gastroenterology, accounting for just over 30% of sales. The only product here is ASACOL, used to treat ulcerative colitis.

Remaining product categories generate just over 10% of sales and include dermatology (DORYX for severe acne), urology (ENABLEX for overactive bladder), and various other minor products, as well as contract manufacturing agreements.

Warner Chilcott is an interesting case. There are many positives things to point to here. First is the valuation. EBIT/EV earnings yield is an attractive 14.1%, and the price/sales ratio is just 1.2, well below the roughly 2.0 average for pharma firms. The company is highly profitable, running robust operating margins over 30%. Cash generation is outstanding. Free cash flow has averaged 140% of reported operating earnings over the past 5 years, one of the highest conversion ratios I've ever seen. As a result, WCRX's free cash yield is substantial, over 15%. Put it simply - the stock is cheap and the company generates a ton of cash flow.

This cash flow (combined with new debt) has allowed Warner to pay their shareholders lavishly over the past few years. The firm paid a $8.50 special dividend in 2010 (a nearly 35% yield at the time). It followed that up with another $4 special dividend back in September (31% yield). Recently, management has also declared a recurring $0.50/year dividend, which amounts to about a 4.1% ongoing dividend yield. This will be well covered at current cash flow levels, a payout ratio under 15%. In a nutshell, going forward WCRX should be a pretty good income instrument for dividend-loving investors.

So that's the good news. Now let's get to the bad news, and the reason I see WCRX as just a "fair" choice for Magic Formula® (MFI) investors.

The biggest issue here is growth potential... there just isn't much outside of a prospective acquisition. Warner's second largest product, ACTONEL, has lost patent exclusivity in Europe and has experienced declining prescriptions in the U.S. (down 37% in most recent quarter), resulting in a 30% sales decline run rate so far this year. ATELVIA, its replacement, has only managed to ramp up to 1/10th of ACTONEL's sales, after a year on the market. ASACOL (the largest product) is seeing flat sales and faces patent expiration next year... it is unclear whether its successor, ASACOL HD, will be able to grow sales further. LO LOESTRIN is growing nicely but is still just replacing declines in LOESTRIN 24. The only real new growth product in the portfolio is ESTRACE, which is about a $400 million annual drug growing at about 30%, but this is in a limited market.

Compounding this problem is Warner's business strategy, which focuses on product life cycle management and profitability instead of R&D. Warner's new drugs have generally been small advancements on current products, and certainly ATELVIA, LO LOESTRIN, and ASACOL HD fit into this description. The issue here is that, with new healthcare laws, managed care firms may be less likely to cover these slightly improved formulations instead of requiring generic versions of the older drugs (which aren't that different, but are much cheaper). This could make it very difficult for Warner to even replace lost sales, much less grow. Adding to this issue is the fact that the company's pipeline is pretty barren, with nothing of potential even out of Phase II development yet.

Add financial health in as a second concern. Warner's balance sheet is pretty ugly. As of the last reported quarter, the firm carried $3.5 billion in debt, vs. $530 million in cash. Interest coverage ratio was under 4 (I like 5 or better). A poor balance sheet combined with a weak business outlook is perilous territory to be investing into, regardless of valuation.

This will get worse, too. To pay that $4 special dividend this year, Warner borrowed another $600 million, which will put debt over the $4 billion mark. Borrowing to pay special dividends is a pretty awful business practice, in my opinion. The company has done it twice in the past 3 years. Why?

Private equity ownership seems to be the main reason. Up until recently, Warner was 30% ownedby 3 large private equity firms (including Mitt Romney's Bain Capital). It isn't hard to speculate that the two large special dividends were incentive to hold the investment. It may have worked... but then back in September (right after the special divvy was paid), those interests sold 43 million shares at just over $13/share, reducing their interest to under 15%. As a result, I don't expect any more special dividends any time soon.

Perhaps this is for the better, as Warner Chilcott has wasted enough capital on these instead of pursuing acquisitions that can move revenues forward. It's disappointing after management talked so much about acquisition in the last conference call and then blows a billion dollars (much of it financed, no less) on "severance payments" to outgoing shareholders. What a joke.

The valuation and cash flow prevent Warner from being a total loss of an investment, and even assuming sales declines I still think the stock could be worth $20, plenty of upside from the current $12 level. But this is one where there are plenty of risks and questionable behavior from management, so it gets the "neutral" rating and does not gain consideration for a Top Buyrecommendation.

Steve owns no position in any stocks discussed in this article.


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