Hi-Tech Pharmacal An Under Followed Name Worth Following

By Stephen D. Simpson, CFA | July 10, 2012 AAA

Due to the seemingly insatiable appetites of companies like Teva (NYSE:TEVA), Mylan (Nasdaq:MYL) and Watson (NYSE:WPI), there aren't nearly as many independent publicly-traded generic drug companies as there used to be. While scarcity value alone is not a good argument for considering Hi-Tech Pharmacal (Nasdaq:HITK), this company's focus on higher-barrier products and over-the-counter (OTC) cold and cough business, coupled with little sell-side support, could make it a potential hidden gem at some point.

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Fiscal Fourth Quarter Results Disappointing, but not Disastrous
Hi-Tech's fiscal fourth quarter results don't exactly establish the case that this is a must-watch stock for investors seeking out small-cap growth names.

Revenue was up 7% (and a little stronger than expected), with 10% growth in the generics business. Sales of the key drug fluticasone (a generic form of Glaxo's (NYSE:GSK) Flonase) rose 6% - again, a little better than expected, but not exactly strong. The entry of Wockhardt has taken some share away from Hi-Tech Pharmacal, but the company seems to be largely holding its own.

Hi-Tech's other line items, OTC products ((reported as Health Care Products (HCP)) and branded drugs ("ECR Pharmaceuticals") had radically different results. HCP revenue jumped 59% despite a weak cold/flu season, largely on the strength of mergers and acquisitions. ECR saw revenue drop 44% on a product line discontinuation. Investors should note, though, that when combined these two units are less than 15% of revenue.

Where Hi-Tech really disappointed me was on the gross margin line. Gross margin dropped about three points due to weaker fluticasone pricing and the drop in branded drug sales. The company continued to grow its SG&A and R&D efforts, though, and that helped push operating income down 28%.

SEE: Understanding The Income Statement

Building Around Core Competencies
Smart small companies focus on doing a small number of things better than their larger rivals, and Hi-Tech seems to be following that plan. It has focused largely on liquid and semi-solid dosage forms, giving it a leveragable product or market niche. At the same time, the company looks to take on products with higher barriers to entry (often harder to formulate or manufacture). This is a sound strategy, as it can allow the company to realize higher prices and margins than would otherwise be the case in "mass market" generics.

The company is also being prudently aggressive about growing its business. There are 14 products awaiting approval from the FDA, and another 20 in development. The largest among them (in sales potential, at least) is a generic form of Asacol - a bowel-specific anti-inflammatory drug that Warner Chilcott (Nasdaq:WCRX) markets for IBD, ulcerative colitis and Crohn's. Hi-Tech is partnered with Par Pharmaceuticals (NYSE:PRX) for this drug and it could be a significant contributor to earnings, though approval and launch timing is still uncertain and Warner Chilcott has been trying to migrate patients to different, still patent-protected forms of the drug.

Time to Be More Aggressive?
With a clean balance sheet, I believe it's fair to ask if Hi-Tech management shouldn't be a little more aggressive. In particular, I wonder if the company could use that balance sheet to acquire smaller generics companies and/or additional branded drugs. There are more than a few branded drugs in the hands of Big Pharma that are profitable, but don't produce enough revenue to "move the needle;" if Hi-Tech could identify a few that are non-core to the current owner, but consistent with Hi-Tech's position in markets like cold/allergy/cough, it could be a "win win" for both parties.

SEE: Earning Forecasts: A Primer

The Bottom Line
This is perhaps not the easiest time to be bullish about the generic drug space. With fewer high-profile branded drug patent expirations on the horizon, investors seem to have soured on the sector's prospects for continued above-average revenue and margin expansion - even though the upholding of the Affordable Care Act would seem to be good news for generic prescription trends.

Likewise, Hi-Tech isn't a slam-dunk growth story. The company is hugely reliant on fluticasone for its profits and rivals like Teva could still enter the market. What's more, management doesn't often target the sort of home run prospects that tend to get sell-side analysts and buy-side managers giddy. All of that said, the stock looks too cheap today and I think investors may want to take a closer look at this name.

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

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