Endo’s Endgame

Leo is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Editor's Note: The initial version contained inaccuracies, this version has been corrected.

Endo Health Solutions (NASDAQ: ENDP), a diversified healthcare company specializing in pain medication, has been sending out mixed signals recently. News of increased federal scrutiny of painkillers, exacerbated by key patent expirations, have caused shares to slide 16% over the past six months. What does all this noise mean for the future of Endo, and how should investors prepare for a chaotic endgame?

A cyclical business

Big biotechs like Endo Health Solutions have always been dependent on their patented medications. However, the more dependent they are on patented medications, the more cyclical and riskier the stocks are. As patents expire, new products - sometimes blended from existing ones - must take their place, or steep declines in revenue will follow. Therefore, the industry also creates generic, non-patented products to offset possible losses from its leading patented ones.

61% of Endo’s 2011 revenue was generated from sales of patented medication, while 21% came from generic ones - which were gained from its $1.2 billion acquisition of Qualitest Pharmaceuticals from private equity firm Apax Partners in 2010. Another 11% is generated from sales of medical equipment.

Endo is the product of a spun-off buyout by three DuPont Merck executives in 1997. Its patent portfolio includes 12 important brands - including prescription painkillers Percocet, Percodan and Opana. It also produces Lidoderm, a popular painkiller patch which generated $825 million in sales in 2011 -- accounting for 30% of Endo’s annual revenue.

Painkiller deaths rise

However, a recent report revealed that fatal painkiller overdoses in America have now risen for 11 consecutive years. As a result, federal regulators are now investigating how painkiller manufacturers have been producing and marketing their products.

The government is particularly interested in the promotion of Endo’s popular Lidoderm patch. Endo is already expecting to take losses, setting aside $194 million to cover possible penalties.

Patent expirations

To make matters worse, Endo’s first Lidoderm patent expired last May, and its second one will expire in March 2014. This has allowed manufacturers to create generic versions of its first generation product.

Generic drug manufacturer Actavis (NYSE: ACT), which won a patent infringement suit against Endo, announced that it is producing a cheaper, generic version of Lidoderm which will become available in September 2013. Actavis, formerly known as Watson Pharmaceuticals, will be required to pay royalties of 25% on early sales to Endo.

Actavis was also allowed to sell a generic, lower-dosage version of Endo’s Opana ER narcotic painkiller in September 2012, despite the actual patents expiring in September 2013. Impax Laboratories was also granted a similar license to sell generic Opana ER in January 2013.

I'm in trouble, and I'm on sale!

With all these headwinds threatening to push the company off course. Initial reports claim that Warner Chilcott (NASDAQ: WCRX) and Valeant Pharmaceuticals International (NYSE: VRX) have expressed interest in acquiring the beleaguered drugmaker. Yet investors should wonder if a company being squeezed by the government and patent expirations can attract much of an acquisition premium. After all, the company has already warned that it does not expect to meet either top or bottom line growth expectations for fiscal 2013.


In the middle of all this news, Endo appointed a new CEO, Rajiv De Silva, a former executive of Novartis and Valeant Pharmaceuticals - to replace retiring CEO Dave Holveck. De Silva can be considered an expert at acquiring and integrating companies in the biotech field - during his time at Novartis and Valeant, he oversaw 40 acquisitions.

While this bodes well for any future acquisitions, it is also puzzling for investors. Does Endo have a contingency plan for the future?

The Foolish Fundamentals

Patent expirations and government probes aside, we should take a look at how Endo measures up to two larger industry peers - Abbott (NYSE: ABT) and Pfizer (NYSE: PFE) - on a fundamental scale.

<table> <tbody> <tr> <td> </td> <td><strong>Forward P/E</strong></td> <td><strong>5-Year PEG</strong></td> <td><strong>Price to Sales (ttm)</strong></td> <td><strong>Debt to Equity</strong></td> <td><strong>Price to Book</strong></td> <td><strong>Return on Equity</strong><br /><strong>(ttm)</strong></td> <td><strong>Profit Margin</strong></td> <td><strong>Fwd. Dividend Yield</strong></td> </tr> <tr> <td><strong>Abbott</strong></td> <td>15.21</td> <td>1.48</td> <td>1.35</td> <td>76.36</td> <td>2.02</td> <td>23.23%</td> <td>14.95%</td> <td>1.60%</td> </tr> <tr> <td><strong>Pfizer</strong></td> <td>11.39</td> <td>4.49</td> <td>3.35</td> <td>47.36</td> <td>2.42</td> <td>11.56%</td> <td>24.70%</td> <td>3.50%</td> </tr> <tr> <td><strong>Endo Health Solutions</strong></td> <td>6.58</td> <td>1.23</td> <td>1.14</td> <td>165.47</td> <td>1.85</td> <td>3.35%</td> <td>0.41%</td> <td>N/A</td> </tr> <tr> <td><em>Best Value</em></td> <td>Endo</td> <td>Endo</td> <td>Endo</td> <td>Pfizer</td> <td>Endo</td> <td>Abbott</td> <td>Pfizer</td> <td>Pfizer</td> </tr> </tbody> </table>

Source: Yahoo Finance

Although Endo definitely looks the cheapest, it also has the highest debt ratio, the lowest return on equity and the slimmest margins. It also doesn’t offer a dividend - making it a weak choice, considering the only real reason to own this stock is to await a buyout offer.

Top and bottom line growth over the past five years also tell a similar story.

<img src="http://media.ycharts.com/charts/c334204631d1aa54fde664b91fde1007.png" />

ENDP Revenue TTM data by YCharts

Endo’s top and bottom lines are the most chaotic, with revenue growth easily outpacing its peers, but with profit growth remaining the least impressive of the group.

The Bottom Line

By all measures, Endo Health Solutions is an unattractive investment. It currently faces a dreaded double whammy of government intervention and patent expirations - which have derailed thriving biotechs in the past.

However, Endo’s endgame is worth watching, since the results of the government probe could seriously impact Actavis’ generic Lidoderm sales. Endo’s portfolio could also seriously boost Warner Chilcott and Valeant Pharmaceuticals’ market presence, which may attract other serious suitors to the table.

Leo Sun has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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