Description

TARO Pharmaceutical Industries (TAROF) is a generic drug manufacturer based out of Israel with its functional headquarters in the United States.  It is controlled by Sun Pharmaceuticals (Sun), a large Indian pharmaceutical company, who owns approximately two thirds of TAROF equity.  An investment in TAROF offers upside of 50% to 100% upon TAROF's relisting on a nationally recognized exchange and the inevitable buyout of the remaining public shares by Sun.   

TAROF manufacturers over 200 different prescription and OTC products in facilities located in the US, Canada and Israel.  Their main area of expertise and specialization is dermatological creams, ointments and gels.  Sun's purchase of a majority of TAROF was held up for a number of years as TAROF's founding families fought Sun over the price Sun was paying for their shares.  During this time period TAROF did not issue audited financials and their stock was delisted and began trading on the pink sheets.

Sun finally was able to resolve their ownership fight in late 2010 with their ownership moving up to 66.3%.  This has lead to TAROF issuing year-end 2010 financials in late June.  Once TAROF issues their quarterly financials they should be caught up to reporting requirements of the major exchanges and become eligible to relist their shares.  TAROF has issued press releases for the first half of 2011 and the results have been strong.  With the costs of fighting Sun and the heavy lifting of recreating historical financials behind them, TAROF's selling general and administrative expenses have fallen markedly.

Sun has a track record of running pharmaceutical operations at much lower costs than TAROF and if the first two quarters of Sun management is any trend, TAROF is going to be a much more profitable business in the future than it was previously.  Sun had accomplished this feat with Caraco, which was another US pharmaceutical company it partially acquired and managed.  Caraco was finally acquired by Sun after it resolved a manufacturing problem that undermined its initial success.

Sun has acquired 13 pharmaceutical companies since 1997 and currently generates about $1.4 billion in annual revenue.  Based on 2010 figures, TAROF is about ¼ the sales and EBITDA of SUN.  While Sun is now consolidating TAROF's financials into their numbers and operating the business, it does not have access to the meaningful free cash flow generated by TAROF. 

VALUATION ANALYSIS

I have included two methods of valuing TAROF shares based on current publicly traded company multiples and a merger and acquisition analysis. 

The public comparables I used are Teva (TEVA), Mylan (MYL), Perrigo (PRGO) and Watson (WPI).  These stocks trade at average and median EBITDA multiples of 10.5 and 9.4 times, respectively.  For EBIT multiples the results are an average of 14.4 times and a median of 13.9 times.  Using the mid points between the average and median multiples yields the following projected price for TAROF stock of between $27 and $31 per share based on 2010 financials and $34 and $42 on 2011 financials, respectively.  The projections below are my own and have the benefit of six months of actual numbers that are well ahead of 2010 results.

Using a comparable merger and acquisition analysis yields significantly higher multiples of EBITDA and EBIT.  The transactions I used for comparison are King Pharmaceuticals (KG), IVAX Pharmaceuticals (IVX), Andrx (ADRX), Bradley Pharmaceutical (BDY), Bentley Pharmaceuticals (BNT) and Eon Labs (ELAB).  Average and median EBITDA multiples for these transactions are 19.3 and 19.0, respectively.  Average and median EBIT multiples are 31.2 and 34.7, respectively.  The deals are listed below:

These multiples yield share prices of $50 to $64 on EBITDA multiples and $70 and $95 on EBIT multiples.  Even using the lowest multiples of 15 times EBITDA and 16 times EBIT yields transaction values of values between $35 and $50 per share.  Here are the tables below with actual 2010 and projected 2011 numbers:

EXPECTED SCENARIO

I believe the improvement in the trading in TAROF's stock price will be a two step function.  The first major step will be TAROF's filing of timely financial statements which will enable TAROF to list on a major exchange.  Once that occurs I would expect the stock to begin trading more in-line with its peer group.  Using a 20% discount to the group's average would yield a multiple of 8 times EBITDA or roughly $30 per share, which is approximately a 50% premium to current trading multiples.  Should any analysts decide to follow the stock that discount would probably shrink over time.

I also believe that at some point in the not too distant future, Sun will want to be able to access the excess cash and cash flows at TAROF.  TAROF is approximately 20% of the overall business of Sun and its results are being closely monitored by the 30 plus analysts that cover Sun in the Indian equity markets.  Sun management spent quite a bit of time on their last call answering questions on TAROF.  Sun currently trades for 28.1 times EBIT and 25.2 times EBITDA.  Any transaction whereby Sun acquires the rest of TAROF's common stock for a lesser multiple is highly accretive to Sun's shareholders.  Sun could choose to do this in a number of ways. 

I believe the mostly likely way would be for Sun to make a cash offer for the remaining TAROF shares.  At 15 times EBITDA that would work out to about $750 million.  Sun could fund most of this purchase with the combined cash from its and TAROF's balance sheets at year end.  Secondly, Sun could choose to use TAROF as a means to listing its shares here through an exchange offer.  This might make more sense than it had in the past due to the increased amount of business Sun is now doing in the US.  I would obviously prefer cash, but Sun has a great track record and it would provide a way for US investors to gain easier access to a successful Indian company.

Catalyst