The world of generics and specialty pharmaceuticals includes many companies that fly below the radar of most investors, but Akorn (Nasdaq:AKRX) may be worth the time it takes to know it better. Not only is Akorn a leading player in generic ophthalmology drugs, but the company's acquisition of Hi-Tech Pharmacal (Nasdaq:HITK) looks like an all-too-rare case where both parties in the deal come out ahead.
Investors who took my advice regarding Hi-Tech a year ago are sitting on gains of nearly 50% (though the intervening 14 months was not smooth), but I'm not sure I'd rush to reinvest the proceeds into Akorn. Although I do like Akron and I believe this deal strengthens the company, the valuation there doesn't leave a lot of upside unless Akorn can drive even better synergies than its guidance suggests.
The Deal
Akorn is acquiring Hi-Tech for $43.50 per share, or $540 million in net cash. That represents a 24% premium to the prior day's close and a slight premium to the company's all-time high in December of 2011. At about 11 times trailing EBITDA, the price Akorn is paying seems fair. Likewise, a discounted cash flow analysis of Hi-Tech suggests that while Akorn is likely to generate a good internal rate of return from this deal, it's paying a premium to what the market should normally pay (as they can realize synergies and cost savings).
What Akorn Is Getting
M&A is commonplace in the generic drug space, as companies like Teva (Nasdaq:TEVA), Mylan (NYSE:MYL), and Actavis (NYSE:ACT) have all used acquisitions to add products and product/manufacturing capabilities, as well as marketing exposure and operational scale. In that respect, then, Akorn's deal for Hi-Tech is broadly consistent with what goes on in this industry.
Hi-Tech will add over $200 million in revenue to Akorn from day one (increasing the revenue base by two-thirds), and although Hi-Tech has posted lower gross and operating margins, Akorn believes they will wring meaningful synergies from the deal. On a 2013 full-year run rate, Akorn management believes the deal will be 40% accretive as the company can unwind overlapping SG&A costs and eventually pursue better manufacturing and logistical efficiencies.
Scale, And More
Were this deal just about operating leverage, it would be likely be worthwhile on its own merits. What makes the deal more interesting, though, is what Hi-Tech can add above and beyond its scale.
Hi-Tech has a meaningful OTC health care business focused around cold and cough medicines and treatments. While competing in OTC cold and cough means competing with companies like Johnson & Johnson (NYSE:JNJ) and Procter & Gamble (NYSE:PG), it's a large market with good margins.
Hi-Tech also has a strong history in liquid and semi-solid generic formulations, as well as difficult-to-manufacture generics with higher barriers to entry. While investors often seem to think that “all generics are the same”, that is very much not the case and there can be substantial differences in margins when selling difficult-to-manufacture drugs. Adding those capabilities should enhance Akorn's own possibilities and addressable markets. It's also worth noting that while Akorn has more than three times the number of pending Abbreviated New Drug Applications (ANDA) with the FDA (57 versus 18), the difference in branded sales is closer to 2x ($5.6 billion for Akron versus $2.6 billion for Hi-Tech), highlighting Hi-Tech's focus on high-barrier/high-opportunity generics.
The Bottom Line
Incorporating Hi-Tech into my Akorn model suggests an increase in fair value of about $1.50 to $3.50 depending on certain assumptions about long-run synergy and revenue growth. Normally that would be great, but with Akorn's stock already up nearly $2 on the news, it's not like the Street didn't notice those benefits. Even so, this deal does make Akron a stronger company and the shares may still be undervalued by 5% to 10%. That's not quite enough to coax me to buy today, but with Akorn now a stronger, more capable generics and OTC company, it's a name that is worthy of due diligence in the hopes of getting the shares cheaper somewhere down the line.
Disclosure – As of this writing, the author has no financial positions in any companies mentioned.