- Lannett Company provides products its customers require.
- By its very nature, it provides them at a lower price than many competitors.
- The business is priced at a low earnings multiple for its industry and the actual valuation is even better.
- Aging populations and rising incomes around the world virtually assure future growth.
Driven by the irreversible trends of an aging population and the rising healthcare spending that comes with it, businesses that can provide products that treat our maladies and help reduce the cost of care will inevitably prosper. With its currently low valuation, improving earnings projection and rock solid balance sheet, Lannett Company (LCI, Financial) currently offers investors a truly compelling opportunity to achieve spectacular returns on capital invested now, before the price rises.
Lannett Company develops, markets and distributes generic versions of branded pharmaceuticals in the United States. Its products cover a wide range of applications from treatments for glaucoma and migraine headaches to irritable bowel syndrome and HIV. One of the interesting aspects in reviewing the list of maladies for which Lannett has treatments is that most of them are chronic conditions rather than curable ones. This permits the company to acquire customers for life across many of the drugs it produces. It doesn’t get much better than a business that acquires customers for life; but, as you are about to see, it can get better when that business is selling at an absurdly low valuation.
How cheap is Lannett?
Businesses that provide products essential to the health and wellness of their customers are generally assigned a premium valuation due to the added certainty this characteristic brings to their ongoing sales and profits. When this situation can be combined with favorable demographic trends, such as an aging population in this case, it simply adds to the attractiveness of an overall industry. In the case of Lannett, you can see from the table below that, while the pharmaceutical industry as a whole enjoys a nice premium valuation to the market, this business is priced much more in line with the valuations of the broader indexes and well below its general industry averages.
Based upon the company’s most recent quarterly SEC filings for the quarter ended September 30, 2014, Lannett has approximately $272,229,000 of cash, short-term investments, receivables and inventory on its books against total liabilities of only $41,393,000. With 35,654,000 shares outstanding for the company, this leaves a balance, net of all liabilities, of $6.47 in cash and reasonably liquid assets on the balance sheet of the business. This amounts to approximately 15.4% of the total market capitalization of the business. Calculating the P/E ratio less these liquid, free and clear assets reduces the current ratio to an even cheaper 10.21 times current year earnings or less than half the industry average. This business is cheap and possess a rock solid balance sheet that provides an added margin of safety to shareholders.
It does look cheap; but is it profitable?
It is really not unusual to find businesses that are priced cheaply relatively to their overall industry and there are normally good reasons why that situation exists. Most frequently, the reasons can be found in the profit margins of the business. After all, having good products to sell in an excellent industry does not make for a great investment if the market prices do not allow the company to produce exceptional gross and net margins. But, what constitutes exceptional margins can only be assessed through industry specific comparisons.
As clearly indicated by the table above, both the gross margins and net pretax margins enjoyed by Lannett are excellent and far superior to the overall average for the pharmaceutical industry. Businesses that have exceptional profit margins will eventually see that performance reflected in superior stock prices. It can be hard to predict when that will happen; but, history shows that it will. Thick margins ultimately are rewarded with favorable business valuations.
The business is cheap and profitable; but is it growing?
So, we have established that Lannett is priced low, has a rock solid balance sheet that provides us with downside protection and enjoys exceptional margins on the products it sells. As investors, when we allocate our capital to a particular business, it is also imperative to know we purchased it cheap and that we have a high level of safety for our capital; but we also need to be able to have a high degree of confidence that the business will grow and provide us with a rising share price that increases the value of our capital for years to come.
Early on in this analysis, I discussed the trend toward an aging population. In the U.S. alone, the percentage of the population over 65 years of age is expect to rise from 12.4% in 2000 to 19.6% in 2030. As shown in the table below, at age 65, healthcare spending begins to rise rapidly.
Now we can plainly see that we have the beginning of a perfect storm forming for healthcare-related business as the general population ages and the level of healthcare spending explodes as we get older. This combination will cause evermore focus on ways to control healthcare expenses and one of the most frequently discussed ways to reduce healthcare spending is through the use of generic drugs. As our system moves more and more to higher deductibles and lower reimbursement rates for name-brand drugs, cash-strapped seniors will naturally migrate toward generic drugs in favor of the name brands. Lannett is perfectly positioned to profit from this building trend.
The analysts covering the stock seem to agree based upon their forward growth projections illustrated below.
As the table shows, Lannett is projected to grow its earnings at 17.5%/year over the next three to five years; a pace more than twice the rate projected for the overall pharmaceutical industry.
What is the upside potential of this business?
One of my favorite ways to estimate the real value of a business for individual shareholders is through the use of the growth rate of shareholder equity. The company’s annual report states that on June 30, 2009, that shareholder equity stood at $77,647,623. By June 30, 2014, that figure had increased to $294,765,000 representing an annualized return on shareholder equity of 33.59%. This is an extraordinary figure and represents the rate at which the portion of the business owned free and clear by shareholders has increased. How many other places do you know of where you can put your capital and have the real value increase by that much? In today’s world, the share price of Lannett could double tomorrow and the business would still represent a reasonable value.
A more common valuation metric used by investors is the P/E multiple compared to the overall multiple applied to its industry. As the first table revealed, the current P/E multiple of Lannett, at about 15.78, would have to rise approximately 67% to reach the industry average of 25.55 times trailing twelve months earnings. A P/E multiple simply equal to the industry average would cause a rise in the share price from Friday’s closing price of $42.13 to $70.36/share.
Since profitable investing is all about what will happen in the future, rather than what has happened in the past, we need to look at analysts covering the stock believe is coming in the future and how that view has been changing in recent times. Over the past 90 days, the average earnings estimate for the year ending June 30, 2015 of the analysts covering the stock with earnings estimates has risen from $2.75/share to the current level of $3.49/share; a stunning 26.9% increase in the projected earnings in just 90 days! This group of analysts also predicts Lannett will continue to grow earnings at a rate of 17.5%/year over the next 5 years as well. If we simply apply a very conservative value of a PEG (price to earnings growth) ratio of 1 to this stock, we would obtain a current fair value estimate of $61.08/share or 44.9% above the current share price. I am less conservative, but much more realistic, PEG multiple of 1.5 would place the fair value of this stock at $91.61/share; an increase of 117.4% above the current price.
We should also keep in mind that none of the valuation metrics just presented have assigned any value at all to the $6.47/share of current, easily liquefiable assets on the books above and beyond what would be required to retire 100% of the total liabilities of the business.
The real slam-dunk
The final consideration I like to apply to any investment is whether I could buy the entire business with no cash down and still enjoy a huge return with a high margin of safety?
As the case has been presented above, a business possessing the future prospects and balance sheet boasted by Lannett should easily qualify for an investment grade rating if it chose to issue some corporate bonds. However, since I prefer a very conservative approach in my analysis work, I am going to assume any bond issue would be rated as “high-yield” or what are commonly known as “junk” bonds. At this time, junk bonds are yielding about 6.42%. If I wanted to purchase the entire business and issue bonds to finance the purchase price, I would need to sell bonds with a face value of $1.51 billion. At an interest rate of 6.42%, $96,942,000/year would be required to service the interest on this debt.
Based on the analysts’ projections of $3.49/share earnings for the current year ending June 30, 2015 and the 35,564,000 shares outstanding, we can expect Lannett to earning approximately $124,118,360 in the current year. This would leave a net earnings after debt service of $27,176,360 or interest coverage of 1.28. Not a great cushion; but a cushion nonetheless. Also, keep in mind that this calculation would retain the net $230,836,000 free and clear of all liabilities that currently sits on the balance sheet in the form of cash, short-term investments, receivables and inventory. So, we have a business that can buy itself and still have over $230 million lying around loose. I would say that constitutes a compelling value.
Final thoughts and actionable conclusions
The drug industry will certainly be with us for the foreseeable future. The current demographic trends in the aging population and the rising amount of healthcare expenditures that will accompany those trends virtually assure rising profits for the prescription drug industry. The desire to control costs also enhances the probability that the growth will be centered on the generic drug business.
Today, shares of Lannett provide us with a compelling value and an opportunity to take advantage of two irreversible trends as they really begin to move in high-speed growth patterns. It is rare to find such an outstanding value with large downside protection and huge upside potential and we should not let it slip away.
Buy shares of Lannett Company up to $45/share and stick them in a drawer for the next few years until you have doubled your money. At that point, sell half and ride the rest of this position higher with someone else’s money while using a 15% trailing stop to exit the position.
