3 Undervalued Generic Producers To Buy

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

Any casual observer of the BioPharma market could tell you that the market is on edge about patent cliffs. The result of this is that there is a lot of potential to be had in generics. The first company that is able to successfully introduce an alternative to an original drug receives, under domestic law, a 180 day period of market exclusivity on generics. As the major producers rush to release the ideal alternative, the race is bound to skew speculation in a positive direction for the bulls. But which ones will come up on top?

Strong Execution At Mylan (NASDAQ: MYL)

The generic producer has been on a dramatic rise from its 52-week low--gaining nearly 50% in value. And for good reason. Over the last 5 quarters, management has consistently outperformed expectations with an average beat of 6.6%. Canaccord recently upgraded the stock to a "buy" in light of the analyst's expectation for accretive deals in the near future. Momentum has certainly been strong with revenues rising 20% y-o-y in the most recent quarter--particularly impressive, since more was achieved in this quarter than in all of 2008 with roughly the same assets. Performance has been so strong that management upped its EPS guidance range to $2.50 - $2.60.

The target 2018 EPS of $6 has also been reaffirmed. If this is achieved, the stock will be worth $78 at a 13x multiple. Discounting backwards by 10% yields a present value of more than $44. The prevailing price is just north of $25.50, so there's plenty of margin of safety in making an investment. This undervaluation is complemented by how the company has swiftly mitigated risk and successfully absorbed price cuts. Meanwhile, substantial free cash flow generation has helped to reduce leverage, and this improved financial flexibility will foster confidence.

Mylan certainly has an attractive pipeline. 47 new products were launched this year. And demand has increased in emerging markets to maintain the aggressive growth story. With the stock trading at just 9.2x, the downside is relatively small.

Untapped Potential For Watson Pharmaceuticals (NYSE: ACT), Teva (NYSE: TEVA)

Mylan is not the only generic producer that has been on a roll over the last 12 months; Watson Pharmaceuticals is up 26.3%. The latter will change its name to Actavis in 2013, since that brand has recognition in over 40 countries--including emerging markets that represent attractive catalysts. This acquisition was a game-changer and turned Watson into the third largest producer of generic drugs. In 2011, Actavis produced 22 billion capsules and tablets. Equipped with an active supply chain that reduces lead times, integration is likely to drive substantial cost synergies. 

Watson recently gained FDA approval on its Abbreviated New Drug Application ("ANDA") for the generic equivalent of Revatio, which it plans to get out to the market as soon as possible. In fact, Waston has over 130 ANDAs pending approval from the FDA. Its early-mover advantage can be seen with the launch of a generic equivalent of Lidoderm, which earned the company 180 days of market exclusivity. The original drug brought in $800 million to its producer in 2011, so the market returns will be substantial. This deal also brings in a strong amount of recognition that will drive momentum elsewhere.

Meanwhile, the largest producer of generics in the world, Teva, has gone nowhere but down ~4.5% over the last 12 months. I still find the company irrationally discounted to intrinsic value. The Israeli company trades at only 6.8x forward earnings and generates attractive free cash flow. When you consider that the company has traded between 11.1x to as high as 25.1x over the last two years, it becomes apparent that risk/reward is very favorable. 

Free cash flow is also quite considerable with an average of $2.8 billion generated annually over the past 5 years. This comes out to a 7.7% yield against the market cap--not excellent, but strong enough in light of consider earnings growth. If Teva is able to achieve just a fraction of the forecasted 8.3% annual 5-year EPS growth, it should be able to outperform from reasonable multiples expansion alone. For this reason, Teva is an ideal way to diversify.

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