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Tickers in this Article: HITK, MCK, CAH, ABC, GSK, PAR
Amityville-based generic drug manufacturer Hi-Tech Pharmacal (Nasdaq:HITK) is a micro cap that generates considerable profits. We'll look at several reasons why you might want this in your portfolio.

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Nasal Spray
Hi-Tech's first and second quarters in fiscal 2011 were helped tremendously by sales of its Fluticasone nasal spray, the generic version of GlaxoSmithKline's (NYSE:GSK) Flonase. Asthma sufferers know it well. Since Par Pharmaceuticals (NYSE:PRX) stopped making its generic version in April 2010, shortages of the drug continue to plague pharmacists across the country. Hi-Tech has done its best to meet demand, but it too is struggling to keep up. The dual benefit of Par's departure is that unit sales have increased dramatically, and with it, prices. Dollar volume for the company in the first two quarters was $28 million, up almost 500% year-over-year from $4.7 million. Unless someone else steps into the breech, this supply problem isn't going away and that's a great problem to have. Now if it can keep the rest of its generic lineup growing - and that's a big if - profits will flow nicely.

Other Revenue
Although a majority of revenue comes from Hi-Tech's generics business, it does operate three other segments including Health Care Products, which sells cough and cold remedies for diabetics; Midlothian Laboratories, a niche provider of generic pharmaceuticals; and ECR Pharmaceuticals, a producer of allergy products that Hi-Tech acquired in February 2009. In fiscal 2010, only its Midlothian Labs division experienced declining revenues. In addition to lagging revenues, the Midlothian's gross margins are the lowest of all four divisions. Fortunately, Midlothian's revenues represent less than 4% of its overall numbers. In addition, Midlothian divested some nutritional products in July 2009 for which it receives royalty income through July 2012. In fiscal 2010, the company received $3.5 million in royalty payments for Midlothian and several other products. These go right to the bottom line, meaning Midlothian's lack of performance isn't an issue. The company overall is growing.

Insider Ownership
I like companies where the founders or managers have a significant ownership position. It tells me they have a vested interest in keeping the business prosperous. In Hi-Tech's case, David and Reuben Seltzer own 22.7% of the stock. Together they hold 2.95 million shares. Five years ago, the brothers held 2.4 million shares. It's a great sign when management is accumulating shares. Although their percentage ownership has dropped 620 basis points since 2005, it's because the number of shares outstanding has increased to 12.6 million from 7.9 million. The brothers are a smaller piece of an ever-increasing pie and that's never a bad thing.

Valuation
With the exception of 2007 and 2008, the company's net margin in the past decade has never been lower than 8% and currently sits at 20.5%. The generic drug industry's average net margin is 7.4%. Although it possesses a vastly superior net margin, Hi-Tech trades for less than nine times earnings while the industry average is twice that. Back in 2001 when its net margin was 8%, the company's shares traded for 18.5 times earnings. Even if analysts are correct and its April 2012 earnings per share are $2.42, its forward P/E is still only 9.6. Something is not right with Mr. Market. Especially when you consider that the company's beaten analyst earnings estimates by 30% or more in three out of the last four quarters.

Small Customer Base
The biggest risk facing the company is its small customer base. McKesson (NYSE:MCK), AmerisourceBergen (NYSE:ABC) and Cardinal Health (NYSE:CAH) account for 54% of revenues and 66% of accounts receivable. If any one of them decided to take their ball and go home, Hi-Tech would face an uphill battle to replace the lost revenue. However, the odds of this happening are unlikely when you consider it manufactures products such as the nasal spray, which are in short supply. It's definitely something to be aware of, but I don't see it as a deal breaker by any means.

Bottom Line
Hi-Tech's stock gained 406% in 2009, lost 11% in 2010 and is down 7% in 2011. Where this stock goes in 2011 is anyone's guess. What I do know is that this is a great micro cap. Eventually, you'll make good money buying at today's prices. (We look at how the FDA affects the pharmaceutical industry, and how investors can avoid the pitfalls. See Pharmaceutical Sector: Does The FDA Help Or Harm?)

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