By: Steven M. Roge, CMFC
Hi-Tech Pharmacal Co. (HITK) (share price $26.52; intrinsic value $38.83; we recommend buying below $27.18) develops, manufactures, markets, and sells generic, prescription, over-the-counter (OTC), and nutritional products in liquid and semisolid dosage forms in the United States. It produces a range of products for various disease states, including asthma, bronchial disorders, dermatological disorders, allergies, pain, stomach, oral care, neurological disorders, glaucoma, and other conditions.
The company’s generic pharmaceutical products include oral solutions and suspensions, topical creams and ointments, and nasal sprays. Hi-Tech Pharmacal Co. also manufactures and sells liquid ophthalmic, otic, and inhalation products, as well as cough and cold products and prescription vitamins. It markets a line of branded products that include OTC, nutritional lines, and prescription products primarily for people with diabetes.
The company’s product line comprises Diabetic Tussin for the treatment of cough; Zostrix for pain relief; DiabetiDerm, a dermatological and footcare product line; Multibetic, a multivitamin product; DiabetiSweet, a sugar substitute; Nasal Ease for allergy relief; and Mag-Ox line of magnesium nutritional supplements. It offers its products to chain drug stores, drug wholesalers, managed care purchasing organizations, certain Federal government agencies, generic distributors, mass merchandisers, and mail-order pharmacies. The company was founded in 1982 and is based in Amityville, New York. (Source: Yahoo Finance.)
HITK is a small-cap stock with one year of negative expected growth clouding an otherwise bright future. HITK is poised to perform well, based on its diversified product line and the projected growth of the generic drug market.
Generic drug manufacturers are not as glamorous as big pharmaceutical companies that invent, test, and introduce drugs. Patents held by big pharmaceutical companies are revered as the archetype strategy for eliminating competitors, and pharmaceutical industry analysts associate the loss of a patent-protected monopoly as the end of profit to be made by the sale of a given drug. Prices, revenues, and earnings fall off a “patent cliff” when the patent expires, plummeting into fierce price competition between undifferentiated products. Considerably less press is given to the next period in a drug’s market as it becomes available for manufacture by multiple firms.
Though the earnings of pharmaceutical companies drop dramatically at patent expiration, HITK earns profits by engaging in many activities that are associated with “big pharma” companies. Like many generic drug manufacturers, HITK produces drugs that are sold to consumers under a brand name. The active pharmaceutical ingredient may not be patent protected, but the brand is intellectual property that never expires. Moreover, the manufacture and distribution of drugs is a regulated activity that requires the development of standard operating procedures, small clinical trials, and government approval.
Generic drug makers must submit an Abbreviated New Drug Application (ANDA) to the FDA, which must document that appropriate dosage was absorbed by a volunteer test group. The facilitation of this approval process and the development of proprietary drug delivery systems (gels, sprays, etc.) are the basis of a research and development expense that was 4.62% of HITK’s sales in 2010. Proprietary technology, trademarks, and regulatory requirements represent barriers to entry and temper competition.
The generic drug industry is poised to experience a boom in the next five years, as patents on many blockbuster drugs expire. This year, for example, generic drug manufacturers will be able to make and sell drugs whose patents expire in 2011. These drugs had annual sales of $15.3 billion under patent in 2010, and will be new markets for generic manufacturers. Next year, the market value of drugs entering the generics market will double; drugs losing patent protection in 2012 accounted for $33.2 billion in sales last year. In the US alone, drugs with a combined $133 in annual sales will enter the generics market from 2011 to 2016. Clearly, drug manufacturers like HITK will have ample opportunities to gain share of market by launching and selling drug products that were once patent-protected.
HITK’s financial statements reveal that it is a healthy company. Its revenue has grown faster than its expenses, resulting in in higher margins. Its positive operating cash flows cover its investing cash expenditures, too. HITK’s balance sheet shows that the firm is very liquid with a current ratio of 8.04 and holds $32.0 million in cash.
Investors should not be distracted from HITK’s medium- bright outlook by the recent FDA removal of Lodrane. Though the loss of Lodrane will reduce HITK’s annual sales by about $14 million, HITK regularly develops and launches new products for sale. In 2010, the firm had ANDAs pending for 16 products targeting $1.0 billion in annual sales in addition to developing 20 products for ANDA submission which target $3.0 billion in annual sales. The loss of Lodrane revenues is outweighed by HITK’s future growth.
David S. Seltzer is chairman of the board, CEO, secretary, and treasurer of HITK. He has been a director, secretary, and treasurer since 1992. He became CEO in 1998 and officially succeeded his father, Bernard Seltzer, as chairman in 2004 when Bernard took a more advisory role as chairman emeritus. David has been flying solo since 2007, when Bernard passed away. Currently, David and his brother Ruben own 22.4% of HITK shares. Clearly, HITK’s future is controlled by the deeply-entrenched Seltzer brothers.
Fortunately, being HITK’s founding family and major shareholders, the Seltzers have a history of acting in the interest of shareholders. The firm engages in stock buy-backs which counterbalance employee and management option incentive plans, resulting in the slight reduction in outstanding shares from 11.94 million in 2006 to 11.90 million at the end of fiscal year 2010. In addition, management is willing to divest from projects that fail to increase shareholder value. A recent example of such a disposal was the sale of Midlothian Laboratories, a 2007 acquisition. This business segment was disposed of based on declining sales, a refreshingly rational management decision which is in stark contrast to many other management teams who put face-saving and empire-building before growing shareholder wealth.
Using Economic Value Added (EVA) as a metric, we find that family management has not been detrimental to HITK shareholders. The Seltzers have created $6.88 million for shareholders over the last five years, a far cry from value destruction.
Relative value metrics show that investors are paying less for stocks based on grim one-year earnings estimates:
Financial Metric HITK Forest Labs (FRX) TEVA Perrigo (PRGO)
P/E (ttm) 9.54 10.57 13.19 25.87
P/S (ttm) 1.98 2.47 2.67 2.94
P/B 2.08 1.97 1.91 5.20
EV/EBITDA 5.06 5.07 9.14 15.01
ROIC (5 Year Avg) 8.9% 19.9% 7.8% 7.5%
5 Year Total EVA $6.88mm $2.52B $1.40B $154mm
1 Year Earnings Growth Est. -28.1% -67.1% 10.4% 14.6%
5 Year Earnings Growth Est. 13.7% -1.1% 10.9% 13.4%
HITK trades at a lower P/E multiple than drug manufacturing stocks TEVA and PRGO, despite having higher earnings growth estimates over a five -year horizon. Thus, HITK is an attractively-priced prospect for investors with a multi-year time horizon.
HITK can be valued using a capitalized earnings model with a five-year holding period that extends at the end of analyst estimates and a glut of blockbuster pharmaceutical patent expirations. Analysts forecast a 28.1% drop in earnings will be endured this year. In the following four years, earnings growth will proceed at 13.7%. After five years, HITK shares would then assessed or sold at a P/E multiple of 16.
Earnings Years
$2.12 1
$2.41 2
$2.74 3
$3.12 4
$3.54 5
-28.1% Year 1 Growth Rate
13.7% Years 2-5 Growth Rate
16 Terminal P/E
13.9% Discount Rate
$38.83 Total Per Share PV
67.5% Price % of PV
$27.18 30% Discount Price
To achieve a 30% upside, we recommend buying shares at or below $27.18.
Sources: HITK website, sec.gov company filings, Yahoo! Finance, Morningstar.com, EvaluatePharma.com.
Joe Escalada contributed to this article.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours
