Description

We recommend taking a short position in Interpharm Holdings Inc. (IPA). IPA presents an opportunity to short the proverbial buggy-whip company at an outlandish valuation. IPA currently trades for 200 times unlevered free cash flow and 11 times revenue. This opportunity is made possible by a complicated reverse merger that left the capital structure difficult to interpret.

About IPA
IPA is a generic drug company. 70% of IPA’s revenue comes from sales of Ibuprofen (generic Motrin). IPA currently has five drugs under development, but we suspect they aren’t likely to be blockbusters considering IPA spent $200k on R&D in 2002. At any rate, IPA is nowhere near sexy enough to deserve its current valuation.

History of the Reverse Merger
In May of 2003 Atec (previously owned by the Rametra family), the shell company for the merger, was sold and pre-merger IPA (owned by the Sutaria family – related to the Rametra family by marriage) was acquired. The generic drug business is the only continuing operation of IPA.

Sharecount
Pre-merger Atec had about 8 mill shares outstanding, which remain at IPA. Old IPA shareholders received 6.2 mill common shares in the merger. As of 9/24/03, because of option exercises and such, there are 17.4 mill basic common shares.
Pre-merger Atec had about 5.7 mill options outstanding. 5.1 mill options were issued on the date of the merger, presumably to the Old IPA shareholders. As of 9/24/03, after some new option grants, option exercises and such, there are 10.3 mill options outstanding at an average exercise price of $1.17.
Series A, B, C & J preferred are collectively convertible into about 100k shares.
4.9 mill Series A-1 preferred were issued to insiders to retire $3.3 mill of debt. The Series A-1 is convertible 1:1 once IPA reaches $150 mill in revenue. For our purposes we’ll ignore the convertibility of the Series A-1 since we believe that if those revenue levels are ever attained it will be years from now. Dividends from the Series A-1 are included in our financials though.
Now the fun part...
2.1 mill Series K Convertible Preferred were issued to the Old IPA shareholders in the merger. The Series K is convertible based on a formula that takes some time to grasp, but we hope to simplify it for you. The Series K becomes convertible in one-seventh increments beginning 5/30/04 and every 5/30 thereafter (i.e. they mandatorily convert in full over seven years).
The formula as published in IPA’s SEC documents:

4 x (Common shares outstanding at each May 30th including preferred as-converted – common issued pursuant to obligations that arose post-merger – common issued to Old IPA shareholders in the merger) - common issued to Old IPA shareholders in the merger

Based on the equity capitalization previously discussed the formula yields:
4 x (17.4 mill – 0 – 6.2 mill) – 6.2 mill = 38.6 mill Series K as-converted

We’ve excluded from ‘common issued pursuant to obligations that arose post-merger’ the options exercised since the merger because presumably the options that were exercised existed prior to the merger since the new options don’t vest for a couple of years.
The Series K anti-dilution provision gives the Series K holders four more common shares for every option issued pursuant to obligations existing prior to the merger that is exercised. Applying the treasury stock method to the remaining 1.3 mill exercisable pre-merger options (pg. 20 of the 10-K) struck at $1.17 assuming a $5.40 stock price gives us about 4 mill additional shares issuable on conversion of the Series K.

To summarize the capital structure at 9/24/03:


Basic Common 17.4
Dilutive effect of options 1.0
Diluted Common 18.4

Series A, B, C & J .1
Series K as-converted 38.6
Series K anti-dilution 4.0
True FDSO 61.1 mill

Valuation
Stock Price 5.40
FDSO 61.1 mill
Market Cap 330 mill
Cash 5.1 mill (at 9/24/03)
Debt 2.5 mill (at 9/24/03)
Enterprise Value 327 mill

What do we get for $327 mill?

This is how we believe unlevered results look on a run-rate basis:

Revenue 30
Gross Profit % 17%
Gross Profit 5.1
SG&A 2.4
R&D .3
Other .1
Operating Exp. 2.8
Operating Income 2.3
Tax Rate 35%
Net Income 1.5
Preferred Dividends .3
Income to Common 1.2
Add: Depreciation 1.4
CFFO 2.6
Less: Capex 1.0
Unlev. FCF $1.6 mill

We’ve excluded the effects of working capital for the sake of conservatism, though including it could make free cash flow substantially lower.

Enterprise Value 327

Unlev. FCF 1.6
EV/FCF 204x

Run-Rate Revenue 30
EV/Revenue 10.9x

This is clearly outlandish, but what’s a fair multiple? IPA has 20 drugs in its portfolio, 70% of its sales come from Ibuprofen, they spend next to nothing on R&D, 50% of sales comes from two customers, and they have questionable related party dealings. By any measure IPA isn’t worth 200 times free cash flow. Considering IPA is growing revenues fairly quickly – 30% per year according to management’s implicit assumptions (based on the 2009 conversion of the Series A-1 preferred baked into their sharecount table on page 21 in the 10-K) – we’ll assume it’s worth 30 times free cash flow.

Unlev. FCF 1.6
FCF Multiple 30
Enterprise Value 48
Cash 5.1
Debt 2.5
Equity Value 50.6
FDSO 61.1
Fair Value $.83/share

85% appreciation potential for short sellers from this level. Note that the $48 mill enterprise value isn’t far from the appraisal of $50-55 mill given by vFinance in the proxy.

Caveats
1) IPA might be tough to borrow
2) Reasonable people can debate at length about the true sharecount. However, we believe 61.1 mill is the most realistic figure based on present circumstances. Further, based on management’s worst case scenario of 76 mill shares and the most optimistic scenario, we believe 61.1 mill is somewhat of a middle ground.

Catalyst

Realization of IPA’s true sharecount. This is a matter of psychology, but we believe it’s inevitable.