TARO Continues to Post Strong Results

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Taro Pharmaceutical (NYSE: TARO) is an interesting developing story. I continue to believe that TARO's market value is significantly higher than what is reflected in today's market price. TARO's market price is effectively capped from appreciation due to a number of reasons including the pending $39.50 offer from the majority shareholder, the voting for which was postponed back in November with no explanation. In addition, shareholders have questioned the actions of the special committee that, for example, evaluated the $24.50 offer for many months even when TARO was trading at $40.  The special committee recommended the $39.50 valuation, which relied on management estimates that were clearly inaccurate and had little correlation to recent sales trends. It is also not conceivable how the special committee's stated objective of maximizing minority shareholders value  can be met without actually exploring ALL strategic alternatives. The only strategic alternative considered by the special committee was a merger with the majority shareholder.

Also, note for any strategic transaction to go through, the majority of the minority shareholders would have to vote in favor.  There is also a civil suit filed by a TARO shareholder on the merger.

Meanwhile, as expected by most observers, Taro Pharmaceutical continued to post good results. Cash and marketable securities are now at  $486.6 million. In the quarter, TARO generated EBIDTA of $104.0 million and its operating margin was at 56%. The impressive sales growth seen when the volumes declined marginally demonstrates the pricing power and the low competition in the difficult-to-make dermatology generic business. What is important to note is the earnings did not contain any one-off 6 month exclusivity revenues that generic companies are used to. It appears that favorable pricing is due to the lower competition and the market consolidation trends in the dermatology business. During the quarter, the company filed one ANDA (Abbreviated New Drug Application) with the FDA.  With this, 17 ANDAs as well as two NDAs (New Drug Application) await FDA approval.

The arguments for sustainability of these earnings are strong compared to a generic pharma with one-off 6 month exclusivity revenues. The dermatology/topical drugs (ointments, gels) are difficult to make compared to generic pills. This is the reason why there is very little competition from Indian generic pharma companies, which have otherwise been big players in the US generic pharma business for decades. The only competition from India is Glenmark, which has 19 products compared to TARO's 180 products. Dr Reddy's dermatology subsidiary is still fledgling with 2011 revenue of $1.5 million. Most of TARO's competition comes from Perrigo, Sandoz, Watson and Mylan.

If you assume the current quarter's earnings as the run rate, the annualized EBITDA would be $104 million * 4 = $416 million. The majority shareholder's $39.50 offer translates to a paltry 3.1 times this annualized EBITDA!  If you take Bloomberg's median valulation multiple (EV/EBITDA) of 14  in recent pharma M&A transactions, then TARO's value would be $141 per share without accounting for any synergies with a potential strategic acquirer or the impact of EU-Israel treaty. SUN pharma, a generic pharma business consistently trades >20 times earnings. Perrigo, a direct competitor to TARO trades at ~15 times earnings. Strides generic sterile injectibles business was valued at 18-20 times EBITDA by Ernst & Young: FDA's stringent standards, competitor issues and the "niche-ness" are the characteristics or trends in this industry much like in the dermatology sector.  

Also,  TARO's fortress-like balance sheet with just $28 million in debt and $486 million in cash or cash equivalents, gives it the flexibility to grow significantly by making synergistic acquisitions.

Below is the back of the envelope calculation for TARO's market value. When doing comparative valuation of a business, it makes sense to look at the Enterprise Value-EV/EBITDA multiple as opposed to a Price to Earnings (PE multiple) of its comparable peers. EV/EBITDA is capital structure neutral. EV/EBITDA is used as a multiple for comps as it reflects the real earnings power of the entire firm without looking at interest expense.

<table> <tbody> <tr> <td> </td> <td> </td> <td> </td> <td> </td> <td><strong>Valuation</strong></td> </tr> <tr> <td> </td> <td> </td> <td> </td> <td colspan="2">in millions</td> </tr> <tr> <td> </td> <td> </td> <td><strong>Annualized EBITDA~</strong></td> <td><strong>416</strong></td> <td> </td> </tr> <tr> <td> </td> <td> </td> <td>Cash**</td> <td>486.6</td> <td> </td> </tr> <tr> <td> </td> <td> </td> <td>Debt**</td> <td>28</td> <td> </td> </tr> <tr> <td> </td> <td> </td> <td>Share Count</td> <td>44.5</td> <td> </td> </tr> <tr> <td> </td> <td> </td> <td> </td> <td> </td> <td> </td> </tr> <tr> <td> </td> <td> </td> <td><strong>Enterprise Value/ LTM EBITDA Multiple</strong></td> <td> </td> <td><strong>14</strong></td> </tr> <tr> <td> </td> <td> </td> <td> </td> <td> </td> <td> </td> </tr> <tr> <td> </td> <td> </td> <td>Implied Enterprise Value</td> <td> </td> <td>5824</td> </tr> <tr> <td> </td> <td> </td> <td>Implied Market Cap</td> <td> </td> <td>6282.6</td> </tr> <tr> <td><strong>Base Case</strong></td> <td> </td> <td><strong>Implied Value per Share</strong></td> <td> </td> <td><strong>141.18</strong></td> </tr> <tr> <td> </td> <td> </td> <td> </td> <td> </td> <td> </td> </tr> <tr> <td> </td> <td> </td> <td><strong>Illustrative value of upside (Shown for illustrative purpose only)</strong></td> <td> </td> <td> </td> </tr> <tr> <td> </td> <td> </td> <td>Estimated Impact to EBITDA - Synergy Savings*</td> <td>45</td> <td> </td> </tr> <tr> <td> </td> <td> </td> <td>Estimated Impact to EBITDA - EU-Israel Treaty Impact*</td> <td>45</td> <td> </td> </tr> <tr> <td> </td> <td> </td> <td>Estimated Adjusted Go-Forward EBITDA</td> <td>506</td> <td> </td> </tr> <tr> <td> </td> <td> </td> <td> </td> <td> </td> <td> </td> </tr> <tr> <td> </td> <td> </td> <td>Implied Enterprise Value</td> <td> </td> <td>7084</td> </tr> <tr> <td> </td> <td> </td> <td>Implied Market Cap</td> <td> </td> <td>7542.6</td> </tr> <tr> <td><strong>Bull Case</strong></td> <td> </td> <td><strong>Implied Value per Share</strong></td> <td> </td> <td><strong>169.50</strong></td> </tr> <tr> <td> </td> <td> </td> <td> </td> <td> </td> <td> </td> </tr> <tr> <td> </td> <td>Note*</td> <td>Shown for illustrative purpose only<strong> </strong>and the company has not guided</td> <td> </td> <td> </td> </tr> <tr> <td> </td> <td>Note**</td> <td>As of 12/31/2012</td> <td> </td> <td> </td> </tr> <tr> <td> </td> <td> </td> <td>~Annualizing most recent quarter earnings of 104m</td> <td> </td> <td> </td> </tr> <tr> <td> </td> <td> </td> <td>All numbers are approximate</td> </tr> </tbody> </table>


Clearly as shown above TARO's value is significantly higher. An independent special committee formed in consultation with minority shareholders will likely be able to realize this value for all of TARO shareholders. It is in the best interest of shareholders to continue to own TARO and carefully evaluate all the facts governing the company's valuation before exercising their vote for the merger.

Disclosure: The author is long TARO. This is NOT a recommendation to buy any security. I strongly recommend any new investor to look at the TARO-SUN merger filing along with other TARO SEC filings before considering any investment in TARO. If I have made any mistakes or errors, please let me know and I will review it to submit a correction.

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