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Lannett: Risks Overblown, Strong Growth, Trading At 50% Discount To Peers

Summary

Lannett is well positioned to capitalize on the favorable trends and characteristics in the generic drugs market.

Continued vertical integration will allow Lannett to extract higher margins by taking on more manufacturing operations and reducing its reliance on JSP for supplies.

Fears regarding leverage and the KU acquisition are largely overblown; operating synergies are starting to be realized and should offset the recent loss of a major customer.

Lannett's valuation is at a significant discount to its close peers, especially when we consider full-year 2016 guidance.

Although integration risks remain, Lannett trades at a fairly attractive price. In addition, put options provide a good return due to the high implied volatility.

Background & History

Lannett Company, Inc. (NYSE:LCI) is a manufacturer and distributor of generic drugs with a heavy reliance on revenues from drugs that treat thyroid deficiencies and gallstone illnesses. Due to a combination of industry uncertainties, ill-timed acquisitions and lower guidance forecasts, LCI's stock price has been pummeled in the past year, falling nearly 74% from its highs in April 2015.

(Source: YCharts)

Clearly, Lannett is facing some significant problems given the market's reaction and its current valuation. To understand why, we take a closer look at its operating history and business.

LCI has been manufacturing generic drugs for decades, so the company isn't a newcomer to the industry. LCI was incorporated in the early 1990s, and sales have straddled along for much of the past decade without any significant jumps - that is, until 2013 when the company began hiking prices for its portfolio of drugs. This led to a massive jump in revenues and margin expansion, prompting a rapid run-up in its share price. As we can guess, the increased scrutiny on price hiking and strong (but nonetheless empty) rhetoric from presidential candidates have dampened the market's confidence in Lannett's business model, contributing to a lower valuation.

Flush with cash from LCI's strong performance in 2013 and 2014, the management became more interested in M&A, leading to the acquisition of Silarx Pharmaceuticals and Kremers Urban (KU) in 2015. The former was a small acquisition settled for $42.5M in cash, but the latter was a giant - KU was acquired for $1.23B in cash along with an agreement that the seller would be entitled to revenue streams from certain drugs currently produced by KU. Although the deal was well received initially with shares popping on the announcement, it quickly became clear that LCI may have overpaid for KU, and concerns were compounded when it announced KU lost a supply deal with a large customer during the transition, causing LCI's share price to nosedive.

We think there are two key questions to address:

1) Is LCI's model of price hikes and M&A sustainable?

2) How will LCI's acquisition of KU detrimental to the company's future prospects?

After considering these two questions, we think it becomes clear that LCI is undervalued despite its risks and problems with the KU acquisition. We find that bear-case concerns are largely overblown and more than sufficiently accounted for in the valuation. Furthermore, LCI's valuation appears even more depressed when compared to close peers situated at the same level in the generics supply chain. Barring any major mistakes and/or unforeseen adverse regulations, we believe LCI should trade significantly higher once operating performance stabilizes and the incremental contribution from the KU acquisition begins to reflect on its financials.

Our discussion will focus more on the useful business analysis and will omit repetitions of well-known industry trends (i.e. more people turning old, more people getting sick, greater demand for healthcare/geriatric services, more widespread use of generic rather than branded drugs, etc.).

Business Structure

LCI is primarily a wholesaler/distributor as it accounted for nearly 75% of total sales in FY2015. The company also has a fast-growing mail-order pharmacy segment while retail chain operations are slowly shrinking.

(Source: Author's work)

Prior to the KU acquisition, LCI was situated mainly as a distributor and a small manufacturer in the overall supply chain. Although the mail-order segment is growing significantly, it will be at least a few years before segment growth has a meaningful impact on the overall financials.

(Source: The Health Strategies Consultancy, LLC)

LCI's strategy is to become more vertically integrated by manufacturing and distributing a portfolio of specialty generic drugs. Currently, it relies heavily on Jerome Stevens Pharmaceuticals (JSP) for at least 50%+ of annual net sales. LCI essentially has a mutually beneficial agreement with JSP: it is the exclusive distributor in the U.S. for a portfolio of drugs manufactured by Jerome Stevens and in return provides a guarantee to buy minimum dollar quantities of JSP's products at negotiated price levels. The original agreement was for 10 years and came into effect in 2004. In 2013, LCI extended its agreement with JSP for five years, with the contract lasting through May 2019.

The long-term concern here is concentration risk. LCI may be relying too much on JSP for generic drug supply, which gives the latter significant leverage in future negotiations. Of the drugs supplied by JSP, Levothyroxine Sodium and Digoxin account for over 50% of LCI's net sales alone (JSP supplies five generics to LCI in total). The management recognizes this risk and has responded by acquiring Silarx and KU, both of which have significant manufacturing capacity and an extensive portfolio of generics. In that vein, we believe the management is actively seeking to diversify away from JSP's supply chain and become more vertically integrated in the process, which would allow it to extract more profits by absorbing the manufacturer's margins. Given that LCI already has an extensive distribution network in place, the company is well placed to integrate KU's operations.

Given the recent two acquisitions, LCI is successfully transitioning into a more vertically integrated generics provider. Although bears would argue that it overpaid for KU (and we would agree to a large...


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