Endo Health Solutions Needs Some Solutions Of Its Own

By Stephen D. Simpson, CFA | November 07, 2012 AAA

Running a specialty drug business is hard enough on its own - just ask Salix Pharmaceuticals (Nasdaq:SLXP), Forest Labs (NYSE:FRX) or Warner Chilcott (Nasdaq:WCRX) shareholders - but Endo Health Solutions (Nasdaq:ENDP) decided to up the difficulty level up going deeply into debt to fund a diversification into devices, services and medical records. With generics challenging the branded drug business and improvements needed in the AMS business, this is a tricky stock right now. Although Endo has a good history of generating solid free cash flow, I think investors are justified in questioning management's vision and this isn't an especially compelling stock today.

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Disappointing Third Quarter Results Underscore Some Challenges
This wasn't an especially strong quarter for Endo. Revenue fell 1% from last year, missing the average sell-side target by around 5%. The revenue weakness was almost surprisingly even, as all the major units missed. Branded drug sales were 2% lower as 15% growth in Lipoderm was offset by a nearly one-third drop in Opana ER and, frankly, minimal growth outside of Lipoderm. Revenue from the Qualitest generics business was up 12%, while Healthtronics revenue climbed 1%. AMS disappointed again, as sales fell 14% with all three segments showing negative year-on-year comps.

Adjusted gross margin fell about three points, and adjusted operating income was flat. This too was slightly below expectation, and though Endo did beat the average sell-side earnings per share (EPS) estimate, it got a meaningful boost from a lower tax rate and would have otherwise missed.

Not A Lot Of Good News From The Drug Side
Endo is definitely facing some trials and tribulations in the branded drug business. The decision to end further development of Urocidin for bladder cancer was a definite disappointment, though it was likely never going to be even a 10% contributor to segment sales. There are still risks from generics, though, as Impax (Nasdaq:IPXL) is likely to launch a non-tamper resistant form of Opana ER next year and generic Lipoderm could still be on the way in 2013 as well. On the more optimistic side, BEMA Buprenorphine (which Endo is developing with BioDelivery Sciences (Nasdaq:BDSI)) could be a significant contributor in a couple of years, with sales potential in the hundreds of millions if it gets FDA approval. On the Opana ER side, Endo's patents for tamper-resistant formulations should matter, and I believe this drug's sales should recover.

AMS Looking Worse, But Generics Look Good
I didn't like Endo's acquisition of AMS at the time of the deal, and I like it even less now. Although some of the underperformance at AMS is arguably beyond the company's control (and related to FDA warnings regarding surgical mesh), Johnson & Johnson (NYSE:JNJ), C.R. Bard (NYSE:BCR), and Covidien (NYSE:COV) seem to be adapting better. What's more, whatever the excuse, revenue at AMS is now about 80% of what it was before the deal closed; that's not the sort of diversification that Endo needed. On the generics side, Endo should get credit where it's due. This business is growing well in what is not exactly an easy market for generics companies (look at Mylan (Nasdaq:MYL) or Teva (NYSE:TEVA)), and I do see a lot of growth potential even as the pipeline for major branded drugs going off patent in the next two or three years isn't superb.

The Bottom Line
I'd feel better about Endo's prospects if it had a strong tradition of internal new drug discovery and didn't have the acquisition debt that came with its acquisition program. As it is, competing with Pfizer (NYSE:PFE) and Purdue in pain is no trivial manner, nor will turning AMS around be an easy feat. With upcoming generic competition and ongoing challenges in its device business, I could see Endo being one of the few drug/device companies to struggle growing its cash flow over the next five to 10 years. To be fair, that projection includes the assumption that Endo won't be able to match prior free cash flow (FCF) margins in the low 20%'s and will instead convert revenue to free cash flow at a high teens rate. What's more, I think the strange mix of drugs, devices, and services limits the number of potential acquirers. This is a case where I'd love to be wrong, but I don't see a lot of value in these shares today, particularly relative to other specialty drug companies.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

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