Originally published on Seeking Alpha
- Generic drug makers have significant upside potential.
- TARO is an unheralded hidden gem.
- Taro Pharmaceuticals Industries Ltd’s consistent high growth of revenues and earnings, while trading at a cheap price, is a powerful investment combination.
Setting the Stage
If you spend any time in the healthcare equities arena then you have undoubtedly heard of the dominant players in the generic pharmaceutical industry. Mylan NV (NASDAQ:MYL), Teva Pharmaceutical Co Ltd (NYSE:TEVA) and Perrigo Co PLC (NYSE:PRGO) regularly hog headlines with merger and acquisition activities, variations of poison pills and oft-confused shareholders.
But a smaller, lesser-known prescription and over-the-counter pharmaceutical company based in Haifa Bay, Israel, continually shines outside of the limelight. I think it’s worth a closer look.
By law, pharmaceutical companies have 20 years of patented protection from competition to develop, market, sell and profit from their drugs. But after the 20 years is up, the patent expires and company profits generally fall; “patent cliff” is the descriptive term coined for this phenomenon.
The downside potential for the large pharmaceutical companies is obvious, as their previous “cash cow” blockbuster medicine revenues rapidly decrease.
However, for the shrewd investor, the upside can be enormous.
With minimal research and development, other companies can–by law–make generic versions of these drugs once the patent has expired. This competition drastically alters supply and demand dynamics and results in substantially decreased prices for patients who need to take the medications.
It’s the free market at its finest.
While generic drug makers don’t enjoy large profits from exorbitant–even astronomical–prices on certain blockbuster medicines, they can experience high operating and net margins on high volume sales. With experienced management this combination can lead to large profits for the company and, ultimately, its shareholders.
Evidence-based Investing: Meet Taro Pharmaceuticals Industries Ltd
Contrary to most of the current market commentary, we at Vailshire Capital Management, LLC believe that Taro Pharmaceuticals (NYSE:TARO) is a “must own” company in the fantastic and rising generic drug sector.
The fact that it is also unheralded makes it even better.
We’ll start by comparing it to several popular generic pharmaceutical companies that regularly steal the headlines and pique investor interest: TEVA, MYL and PRGO.
Compare and Contrast
Going head-to-head with three more popular competitors draws out several important distinctions. (Note that these statistics were taken from gurufocus.com on 9/29/15.) I’ve highlighted the leading values that Vailshire deems most important when evaluating pharmaceutical companies.
Market capitalization: Vailshire prefers to own companies with smaller market caps, as high levels of growth can generally be sustained for longer periods of time–resulting in an improved stock performance. The market capitalization of TARO is $14 billion less than the next smallest competitor (Mylan) on the chart.
Price-to-earnings (trailing 12 months): For value investors, it’s simple: the lower the P/E, the better. At 10.67, TARO trades at a steep 44% discount to the next-cheapest competitor!
Price/earnings to growth ratio: One of Vailshire’s favorite metrics, TARO’s PEG of 0.23 means that its P/E is really cheap when its earnings growth is factored in. Peter Lynch, the legendary mutual fund manager from Fidelity, would be proud. He liked to invest in companies with a PEG of less than 1.0. Note that TARO’s competitors are nowhere close.
Enterprise value to earnings before interest and taxes: Considered to be a more sophisticated version of P/E, an EV/EBIT of less than 10 for a solid, growing company is fantastic. TARO’s is 7.68.
Yield (%): In terms of shareholder-friendliness, this is the only (very small) strike against TARO. TARO currently offers no dividend, lagging TEVA (2.36%) and PRGO (0.31%).
Return on Assets (%): How much money does the company make off of all the stuff it owns? In TARO’s case, quite a bit: 34%. Its competitors? Not so much.
Return on Equity (%): Of the shareholder’s investments (equity), what kind of return does a company generate? TARO is at 41%, while its competitors range from 1 to 16%.
Net margin (%): What percentage of profits does a company make after deducting expenses? This often reflects the quality of management. Large revenues are one thing, but translating those sales into real earnings is quite another. Again, TARO excels relative to the competition: 57% versus 8.75% (average).
Debt to Equity ratio (%): Another of Vailshire’s favorite metrics. The smaller the amount of debt, the lower the risk of bankruptcy if and when another financial crisis hits. Even in today’s “cheap money” environment, TARO has no debt. That’s zero with a “0.” I love it.
5-year and 1-year revenue growth (%): Are company sales growing at a good clip, and is the growth sustained? Vailshire likes to see companies with revenue growth rates greater than 20% for at least 5 years. If growth is accelerating over the past 12 months, that’s even better. TARO, again, is the clear leader.
5-year and 1-year earnings growth (%): Does the company translate revenues into earnings, and has it done so consistently? Both TARO and MYL are quite satisfactory in this metric.
One of Vailshire’s deepest beliefs is that if earnings are growing, then so too must the stock price. Even if shareholder returns are delayed for awhile, they will eventually–inevitably–be rewarded. When you see growing earnings coupled with a languishing stock price, back up the truck and buy more shares. Gilead Sciences (NASDAQ:GILD), a company about which I have written numerous times, has the same delightful “problem.”
While investment returns are impossible to predict (a prediction, after all, is only just a guess), it behooves us as investors to stockpile our portfolios with the best ammunition. When and how much will TARO explode higher is unknowable. But with so many fantastic growth and valuation metrics within an ever-burgeoning healthcare sector, it is almost inevitable that TARO will be at a much higher stock price in the coming months and years.
Buy TARO and plan to hold for a long time.
Additional disclosure: Vailshire Capital Management, LLC is also long TARO, MYL and GILD within some or all of its clients’ portfolios, as well as within its flagship hedge fund, Vailshire Partners, LP.