Taro is a simple arb opportunity with 15% downside and 45% - 200% upside.   I believe Taro will likely be acquired in the next 6-12 months after Sun once again substantially increases its bid to Taro minority shareholders.  Taro has been written up twice previously at lower levels, and has risen primarily on improved earnings, not multiple expansion.  At only 4.5x run-rate EBITDA, Taro is in fact at one of the cheapest levels it has ever traded at.  Although many here may be familiar with the story on a fundamental basis, I would like to highlight the attractive arb dynamics that have recently emerged that arguably make Taro more attractive than it has ever been.  To reduce risk in Taro’s underlying business, you can short Sun, of which Taro is in excess of 50% of TTM EBITDA.  In addition to the prior write-ups on Taro, I would also encourage you to read the recent letters from minority shareholders, as well as Grand Slam’s recent lawsuit filed this past weekend.

Overview of Situation:

Taro is the leading generic dermatology company in the US.  Sun Pharma owns 66% of Taro and has made 3 separate public offers for the company over the last 4 years, each time at a progressively higher level.  Last October, Sun bid $24.50 for Taro, implying a 7.5x EBITDA multiple at the time, which Taro’s special committee eventually rejected.   In August, Sun revised their bid to $39.50, implying about 4x TTM EBITDA.  This time, Taro’s special committee accepted. 

In order to purchase the company, Sun needs to win a majority of the minority of shareholders that actually vote. With the shares trading at over 15% above the latest offer, anyone who would vote in favor of the bid should be selling their stock in the open market, making it difficult to see how Sun wins the vote here.  Sun’s ability to buy Taro is entirely in the hands of minority shareholders.  I believe Taro is worth up to $140 a share to Sun.  The gap between what Taro is potentially worth to Sun and where it trades today creates a very attractive upside against a floor of $39.50 that has been set by Sun’s recent bid.

Why Sun wants Taro:

Taro today is about 48% of Sun’s TTM EBITDA and 44% of its net income (50%+ of the latest quarter’s EBITDA adjusted for Lipodox going away). Sun has a market cap and EV of approximately $13B.  It trades at 18x LTM EBITDA and 25x LTM earnings.  Putting these same multiples on Taro yields a valuation of $140 a share on a TTM basis.  Sun has stated an interest in expanding its business into the US and has made Taro the way it plans to do that.  Very senior members of Sun’s management team sit on Taro’s board and Taro’s management team is almost entirely Sun-appointed.

Scenario 1:  Base Case – Sun is forced to pay a reasonable value for Taro:

I believe the next step-up in Taro will come when Sun is forced to revise their offer to something more in-line with recent comp transactions.  There have been several recent deals in the generic derm space that clearly suggest a value of at least $65/share for Taro:

Fougera acquired by Sandoz for 8x TTM EBITDA  in June 2012

Paddock acquired by Perrigo for 8.5x TTM EBITDA in July 2011

Sun’s $24.50 bid for Taro in October implied 7.5x TTM EBITDA

Perrigo (the #2 player in generic derm) trades at 14x TTM EBITDA

Although I could make an argument for Perrigo (or Sun) being the best comp, to be conservative, I’d point to the Fougera transaction.  Fougera is the #3 player in the derm space, competes with Taro in many of the same drugs and, like Taro, has benefited from price increases on a variety of products in the last couple years.  Despite these issues (which Sun & Taro frequently highlight), Fougera was bought out less than 6 months ago for 8x EBITDA.  Fougera’s multiple would imply a valuation of approximately $67.50/share for TARO, or up 45%.  This compares to Sun’s bid for TARO of 4.25x TTM EBITDA.

Scenario 2:  Bull Case – Sun pays high end multiples for Taro

Although $67 seems like the low-end of a fair price, I could point to Perrigo’s valuation or Sun’s own valuation, which would yield values for Taro of between $110 and $140 a share for Taro.  Perrigo is Taro’s best publicly traded comp, is most similar to Taro in size, and derives nearly 50% of its EBITDA from its generic pharma business.  Because Sun needs the minority vote to gain full control of TARO, there is a very plausible scenario where shareholders could continue holding out for valuations at these levels and get taken out here.

Scenario 3:  Bear Case

The most obvious way to lose money here is if Sun is somehow successful in pushing the deal through at $39.50.  This would likely have to be done through fraud; considering where the stock price trades today – any rational market participant can sell all their shares into the market today for more than they can get in a scenario where Sun wins.

The second way to potentially lose is if Sun withdraws their bid and the fundamental of the business deteriorate (or if Sun “makes them” deteriorate to depress Taro’s price).  The easiest way to protect against this risk is to short Sun, given the magnitude of exposure Sun has to Taro and its relatively lofty valuation.  This incentive has existed for Sun for nearly 4 years and during that time Taro has seen its EBITDA increase more than 4x, so I view the odds of Sun purposely tanking Taro’s business as reasonably low.  And, if you are worried about this, you can just short Sun, which is not pricing in any meaningful decline in TARO’s business.

What math did Sun use to justify their $39.50 bid and why that math is wrong:

Sun & Taro argue that Taro sales & earnings are likely to decline over the next few years, and value Taro based on 2013 EBITDA of $232M.

These financials were put together by an “independent 3^rd party” in June 2012, and were the basis of the Taro board accepting the Sun bid.  These financials have proved woefully inaccurate despite being put together so recently.  With 3 months to go, Taro has already done 249M in EBITDA and is on pace to do approximately 345M in EBITDA this year.  Considering that the plan was put together near the end of Q2, Taro’s estimates have been woefully off compared to what Taro is on pace to actually achieve:

It’s worth noting that the financials were off in basically every respect possible – Sales were light, gross margins were light, and SG&A and R&D were both too high.  Ultimately Taro is likely to outperform H2 projected EBITDA by about 70%.

Further, Taro’s financial advisor made a multitude of other questionable judgment in their fairness assessment, including:

1)      Using a comp set that includes non-dermatology generic peers (lower quality businesses with lower barriers to entry than in derm)

2)     Using a P/E based valuation that did not take into account Taro’s $8.50 per share of cash.

3)     Citing a 103% control premium being paid by Sun to where Taro was trading nearly a year ago, before Sun’s $24.50 offer, rather than citing the most recent price of Taro, which was actually above Sun’s most recent offer.

Is Taro’s business declining and, if so, does that justify Sun’s bid?

Taro / Sun claim that Taro is seeing volume declines in select products, that 2013 EBITDA should decline, and that their offer is fair on a 2013 basis.  Given how wildly inaccurate Taro’s projections have been, I don’t see how they can be relied upon for accuracy.  Let’s assume for a moment, however, that they are directionally right and that Taro’s 2013 EBITDA will decline 15%.  That would still get us to EBTIDA of around 300M, or a valuation of $62 on the Fougera multiple.  I would note that Fougera has been benefiting from exactly the same price increases / limited competition dynamic that Taro is benefiting from, and still received an 8x multiple on TTM EBITDA despite those concerns.  I would further point out that Fougera had nearly 1/3^rd of its revenue and EBITDA from Immiquimod, which has seen its sales decline 66% since Sandoz bought it.  Immiquimod was a drug Fougera had 40% share in and which was facing clear increased competition, and must have been accounted for in Sandoz’s bid for Fougera.  So despite what will almost certainly be lower 2013 v. 2012 EBITDA for Fougera, Sandoz still paid 8x.