Description

This is a short sale recommendation, and comes with the disclaimer that the borrow is tight. That said I think it’s a screaming short. The thesis is simple – HITK stock is priced as if this is a fast growing business for the next several years, when in fact the company has experienced a one-time growth spurt due to a competitor’s misstep.

Hi-Tech Pharmacal Co. develops, manufactures and markets generic and branded products for the general healthcare industry. The Company’s generic products can be split into four broad categories: cough and cold, asthma, anti-bacteria and vitamins. The Company’s branded products are targeted at the diabetic market. HITK stock is trading at approximately $43 (with 8.0 million fully diluted shares outstanding) and has a market capitalization of approximately $344 million, valuing the company at 6.7x and 5.7x my estimate of 2003 and 2004 sales and 52x and 40x my estimate of 2003 and 2004 earnings per share. HITK currently has no sell-side analyst coverage. Only a year ago the stock changed hands at prices in the mid single digits.

I believe HITK’s recent revenue growth (and therefore shareprice) is not remotely sustainable. HITK has historically been able to grow revenues by 9 – 13% per annum as it has introduced new niche generic products and built a solid branded diabetic drug business. This growth accelerated significantly in fiscal 2003 (April year-end) and, year to date, sales are up over 50%.

1997 1998 1999 2000 2001 2002 2003E
Sales 20.5 22.4 23.3 26.4 29.6 33.3 51.5
Growth 9.3% 3.9% 13.5% 12.2% 12.3% 54.7%

The company has attributed this growth to better distribution and increased penetration within its existing client base for prescription generic drugs. The company’s most recent 10-Q indicates that the growth “came from products not sold in the comparative period”. After receiving clarification from the company regarding the nature of this increase, it appears that the increase was not related to products that the company did not have in its product portfolio in the previous year (ie. new pipeline products) but were actually products that had been available for sale but no sales had occurred because these products were not actively marketed by HITK in the comparative period the year before. According to management, $7.1 million of the $11.8 million increase in generic sales in the first 9 months of FY2003 came from such products. The products that compromised the vast majority of this increase were Sulfamethoxazole (anti-bacteria), Promethazine (anti-nausea) and Lactulose solution (constipation). Of the remaining $4.7 million in organic generic growth through the fist nine months of fiscal 2003, almost half came from albuterol (asthma inhalant).

All of the products that have contributed significantly to the robust FY2003 performance of HITK have one common thread; they have all been produced historically by HITK’s primary rival, generic drug manufacturer Alpharma (TK: ALO). In 2002, Alpharma ceased shipping these products due to FDA problems with its liquid pharmaceuticals plant in Baltimore, Maryland. It is expected that following FDA remediation (which Alpharma expects to complete by the end of calendar 2003), the Baltimore plant will return to full production. As a result, it is unclear where future growth for HITK will come from. In fact, HITK runs the risk of losing share gained in the last year as Alpharma ramps up production. Although some of the share gains may last (Lactulose is a $2mm per year contract with the government), other contracts are of shorter duration and were replacements for ALO shortages. Based on conversations with Alpharma, ALO has made a decision to stop manufacturing certain lower-margin products and conceded the share to HITK and other rivals. In making estimates I give them the benefit of the doubt and assume that HITK is able to maintain the share it has stolen from Alpharma this year and is able to grow at its FY2003 organic growth rate of 17.5% (which includes a yet to be quantified amount of ALO shortage volume), which is significantly higher than HITK’s growth rate in every prior period.

HITK’s valuation is much higher than those of best in class generic drug manufacturers. Generic drug manufacturers trade at 2003E and 2004E earnings multiples ranging from 16.3x – 44.6x and 14.3x – 22.6x with average multiples of 22.8x and 17.7x, respectively. These include best of class manufacturers with significant drug pipelines such as Teva, Mylan, Barr, IVAX and Watson. As mentioned earlier, HITK trades at 51.0x and 39.0x my 2003 and 2004 earnings estimates.

2003 2004 2005
Sales 51.5 60.5 71.1
Sales Growth 54.7% 17.5% 17.5%
EBITDA 11.9 15.1 19.0
EBITDA Mult. 28.9x 22.8x 18.1x
EPS $0.83 $1.08 $1.39
Implied P/E 51.8x 39.8x 30.9x
Free Cash Flow 4.9 7.8 10.3
FCF Yield 1.4% 2.3% 3.0%
Industry P/E 23.0x


HITK’s product line is commodity-like. HITK has five main product categories: cough and cold, asthma, anti-bacteria, vitamins and branded diabetic products. These products are commodity in nature and all face tough competitive end markets. HITK has attempted to move into higher profit and less competitive markets through its new product pipeline, however, to date, HITK has been unable to generate growth through FDA approval of new products. Worth noting – HITK spends a paltry $2mm a year on r&d. This is in contrast to a branded pharma or biotech company short sale idea where you never know if some blockbuster product will end up hitting in the future and costing you a bundle.

There has been a big wave of insider selling. HITK is a family-run business and Seltzer family members own almost 30% of the company. The Seltzers have decided that they do not want to lose control over the company and will only sell shares converted from option grants. All other non-Seltzer senior officers, including the CFO, have sold 100% of their stock holdings, some of it at much lower prices. David Seltzer, the CEO, has sold roughly 700,000 shares (from option grants) since April 2003 and has reduced his holdings from 1.57 million shares to 704 thousand. Who could blame him – this is a solid little company, but in no way does it deserve multiple more than 2x it’s peer group.

Catalyst

Anniversaring of market share wins from ALO, plus ALO plant coming back online, and stock market realization that this is not a hypergrowth company deserving a 50+ P/E, but rather a small, unextraordinary generic drug co. deserving less than half that mutliple.