Description

PRX is a leading generic drug manufacturer that presents a compelling risk/reward opportunity at current prices. Using conservative assumptions, PRX should earn 2.39 in 2005, 3.09 in 2006, and 3.46 in 2007 and should trade at 17x 2007 EPS. This would yield a 2-year price target of $58.78. Importantly, the estimates that I am using are very conservative and it is much more likely that PRX will do much better than my estimates in 2007 than much worse. As long as I am right about PRX's earnings power and the quality of the underlying growth drivers of the company in 2007, it would be very hard for PRX to trade below 12x EPS, which suggests to me the risk of losing money in abosolute terms is very low when you look out two years.

The generic drug sector is a very complicated sector that is really best left to sector specialists who know what they are doing. I have followed the generic drug sector for over 5 years and work as an analyst at a hedge fund where I focus exclusively on healthcare. The interesting thing about the generic drug sector is that one needs to understand a lot of important details of any given company to find opportunity. One of the most important things in the sector is to have a strong relationship with management and to figure out which teams are credible and which ones are not. Because the generic drug companies only reveal a few key stats about their pipeline, you are basically at the mercy of management to characterize their opportunity accurately. A management team that is not credible will lose you a ton of money unless you realize they are not credible. A great management team that you can trust and that has proven to be reliable over time is great and knowing that you can trust them is an important consideration.

The main reason I like PRX is that the company is currently misunderstood by Wall Street. PRX has had a tremendous run over the past few years where the company went from virtually nothing in revenues and earnings to a company that did $800mm in annual revenues and $4.00 in EPS at its peak. The market became enamored with PRX's rapid expansion and took the stock up to $70. However, as anybody who knows the generic industry well will tell you, it is important to take a careful look at the underlying quality of a generic companies earnings at any point in time. Generic drug companies can earn their profits either from products that are already fully competitive, products that are currently only mildly competitive but where future competitiors are expected to come in, products that are minimally competitive and that should remain so for several years, and products in which the company has 180 days of exclusivity from the Waxman Hatch protection. In effect, each of these pdt profites create earnings streams of differing durations. One has to think about how the earnings will unfold over time based on the differing durations of the pdts that are generating the profits at any point in time.

In the case of PRX, when their earnings peaked at $4.00 in annualized earnings, much of the earnings were coming from short duration pdts where future competitive entry posed a risk of taking the earnings down significantly. Sure enough, this happened, and PRX's earnings took a hit and so did the stock.

The good news is that I believe that PRX is now at a new base of earnings of 40c per quarter or $1.60 per year. Importantly, off this base, I see the opportunity for PRX to grow EPS strongly over the next few years. The key drivers to PRX's growth are the following: 1) filing and getting approvals for 20-25 ANDAs per year which should generate an average of $5mm/ANDA in revenues and in aggregate should add about 40c/year of fully-competed EPS to PRX's run rate. So, right off the bat, base earnings power should grow by about 40c per year every year. Keep in mind that the actual pdts that these 20-25 ANDAs represent are undisclosed, so the best we can do is apply conservative assumptions to what an average ANDA will do.

In addition to these 20-25 ANDAs per year, PRX also has several disclosed product opportunities that are very powerful. We know that PRX is challenging J&J's patent for Ultracet. I've done a lot of work on this case and think PRX stands on very solid ground. This pdt should contribute 41c in 2005, 24c in 2006, and 16c in 2007 (profits will go down over time due to competition). In addition, PRX should be in a position to launch several other pdts: Catapress, Calcitonin, and Androgel. In the table below, I show how these different pdts which I believe are high probability launches will contribute to probability-weighted EPS.

Lastly, PRX is pursuing a couple of branded drug opportunites that could be pretty powerful. PRX is working on a branded form of Megace and I think their strategy there will be reasonably successful, especially in 2007 & 2008. PRX is also working on a special form of amoxicillin which could add over $10/share of value if the effort is successful. We have a free option on the amoxicillin opportunity.

To summarize, this is what I think PRX can do over the next 4 years:

2005 2006 2007 2008
Base business 0.76 1.10 1.41 1.71
Pdts at risk of more competition 1.20 1.08 0.97 0.75
Ultracet 0.41 0.24 0.16 0.12
Catapress 0.20 0.25 0.22 0.20
Investment in branded Meg & Amox -.59 -.35 -.35 -.40
Gross Profit from Megace .18 .36 .59 1.19
Launch of undisclosed auth generic.23 .20 .20 .18
Total 2.39 3.09 3.46 3.94

Since I did the analysis above, PRX also signed a deal that gave them access to a couple of other pdt opportunites that can add nicely to EPS. Specifically, the Duragesic product that they got from the recent Abrika deal could add 15c per year for several years and the other four products they got from Abrika could be very nice too.

The key point that one needs to understand is that the $3.46 that PRX is going to earn in 2007 is a much higher quality 3.46 than the $4.00 they earned in early 2004. PRX is going to earn that $3.46 with products that are mostly fully competed and with a couple of longer-life branded products ramping up that will fuel growth in 2008 & beyond. Because of the high quality nature of how PRX will earn their EPS in 2007, I think 17x EPS is the right multiple to use to establish a price target off 2007 EPS.

It is very difficult for me to figure out how to convey everything I know about PRX in this writeup. Because there are so many moving parts and I could talk about any one issue at great length, I think I will stop here and answer questions from those who are interested. Lehman Brothers recently initiated coverage of PRX and I think they did a decent job of both describing the company and the opportunities that PRX has. Unfortunatley, because the generic drug industry is so complex, it seems like no single analyst does a good job of perfectly characterizing the risks and opportunities that a company has, so one has to read all the reports they can get on a given company. The bearish analysts on PRX right now include ThinkEquity and Bear Stearns. I fully understand their argument and I actually have a lot of respect for the work that both analysts do, but I think that in the case of PRX, they are being myopic and are missing the bigger pictures due to some short term concerns that they are fixated on.

Catalyst

1) launch of Branded Megace in ealry 2005, 2) launch of Ultracet in ealry 2005, 3) approval to launch undisclosed authorized generic (which I think is Flonase and shoud come in 6 months), 4) launch of Catapress (which was held up for over a year due to a Citizen's Petition but is now looking like a likely launch in 2005), 5) successful data from the ongoing Pulsys Amoxicillin trial which presents a free option at current prices which would add $10-15 to PRX's stock price if successful.