The AAOI portfolio has decided to initiate a position in Caraco Pharma (CPD).
The investment analysis below is the second write-up in our ongoing series of guest post’s, and is brought to you by Paras Dagli. Paras runs pakiyafunds.wordpress.com – an outstanding blog very similar to our own here at AAOI (we highly recommend it) – and is a contributor to Value Investors Club, Sum Zero, and Seeking Alpha. Per his blog, Paras is fascinated with business, human behavior, and history. He has studied and follows the investment principles used by Warren Buffett, Ben Graham, Charlie Munger, Mohnish Pabrai, and Bruce Berkowitz, and aspires to follow in the footsteps of these great value investors and to use any wealth created along the way to be returned to society. He has been investing in the equity market for the past 5 years.
Paras was kind enough to put together a quick “3×5” analysis and update to what we consider to be a classic low-risk, high-return investment opportunity (for our readers who would like a more in depth breakdown, we recommend clicking on the Pakiya Funds link below). With that said, here’s Paras’s analysis.
CPD Investment Thesis:
Caraco Pharma recently announced their quarterly numbers. The figures weren’t something to brag about but the other operational updates were pleasant news for shareholders. Before we get into the recent updates, lets quickly visit the investment thesis.
Caraco is a small cap generic pharma company. The best way to think about the company is that it is the US-arm of one of the biggest pharma companies in India. Caraco is the operating arm of the most profitable part of a pharma company, manufacturing, distribution and marketing.
Until 2008, the company was making around $30-35M of free cash flow with almost no CapEx and very little going into R&D. Sun Pharma does all the R&D for the generic drugs, Caraco files the drugs with the FDA and then ditributes/markets it. Caraco was growing in the 25% range with over $300 million in sales in 2008. The company had a strong pipeline of over 20 drugs pending FDA approval and had an agreement with Sun Pharma to distribute/market other drugs that Sun Pharma has received approval for. Caraco did not have any risks related to R&D, as Sun Pharma did all the R&D. Caraco was a small cap growing at an exceptional rate with a strong balance sheet, and backing from a big pharma type company.
Although in 2008 the company ran into a major operational problem. The company was found not in compliance with cGMP requirements. Management could not fix the issue quickly and was forced to cease manufacturing until it was back in cGMP compliance. The shares dropped quickly, from $15 to sub-$1, creating a huge buying opporunity that we couldn’t pass up in the process.
In our “http://pakiyafunds.wordpress.com/2008/12/12/caraco-a-misunderstood-generic-pharma/ write-up on December 2008, we discussed the FDA compliance issues the company ran into. The compliance issues forced the company to cease manufacturing until the company was back with cGMP compliance. With that in mind, the company has taken big steps towards getting the company back into compliance. The board replaced the CEO and brought back Jitendra Doshi (Mr. Doshi had guided Caraco through its initial cGMP compliance issues in late 1990s). The company also fired managers of the QA and Compliance team. The company also laid off 430 employees, a cost cutting measure until company could restart manufacturing. The company also signed a consent agreement with FDA in September 2009, creating a roadmap for the company to get back into cGMP compliance and resume manufacturing.
Notably, management has also taken some major steps to prepare the company for strong growth in the future. The company settled the litigation with Forest Labs related to the Lexapro generic drug. The settlement netted Caraco $20M in cash and Caraco took over Forest Labs’ generic arm Ironwood. Caraco also signed a new agreement with Sun Pharma for manufacturing 25 drugs at Caraco’s facilities (Caraco has a 46% gross margin for manufactured drugs).
Now let’s look at the most recent quarterly release. First let’s quickly look at the numbers. Since the company has stopped manufacturing, it is not helpful to look at the revenue or net income numbers. Instead we are mainly concerned with the cash burn.
We want to get an idea on how much cash the company is burning through while it waits to resume manufacturing. In the most recent quarter it looks like the company burned through $5 million of cash. We account for the $5M burn by looking at the company’s operating loss.
The company has $67 million in cash and $10 in short-term investments. The company also has $16 in debt. So the company has $51 million of net cash to help the company wait until manufacturing starts. Although if you look at the other updates in the quarterly release, we think the cash burn is likely done. Going forward, we expect the company to be break even or even to generate a little excess cash, while waiting to hear back from the FDA.
The company announced that it has relocated certain manufactured drugs to off-site, third party, manufacturing facilities.
“Products sold and distributed by Caraco that are manufactured by third parties and outside of these facilities are not impacted and distribution and marketing of these products continues. The Company has also transferred certain Caraco-owned products to additional alternate manufacturing sites that would allow the Company to regain revenues from those products while Caraco completes the necessary remedial actions that would lead to resumption of its manufacturing operations.”
This is exceptional news from a cash burn perspective. We don’t know how long it will take to receive the FDA go ahead. But by moving certain manufactured drugs to other manufacturing sites, the company will be in a position to generate cash while it waits. Also, the resumption of sales of certain generics will help the company’s relationships with distributors and customers. The company has a 46% gross margin on maufactured drugs, so by moving it to third-party sites the company will still make strong cash. Also, this shouldn’t increase any expenses for the company so all the cash should hit bottom line. This is why we believe the $5 million in cash burn will likely not happen again.
The most promising and major update was related to the FDA compliance. Management stated:
“The Consent Decree provides a series of measures that, when satisfied, will permit the Company to resume manufacturing and distributing those products which are manufactured in its Michigan facilities. In accordance with the Consent Decree, the Company has engaged a consulting firm which is comprised of current good manufacturing practice (“cGMP”) experts and has submitted a work plan to the FDA in October 2009 for remedial actions leading to resumption of its manufacturing operations. Some additional details and clarifications to the work plan were submitted to the FDA for its approval on January 14, 2010. As a result of the FDA action, Caraco voluntarily ceased manufacturing operations and instituted, in two phases, indefinite layoffs of approximately 430 of our employees. The Company has subsequently started recalling some of these employees in conjunction with its efforts to restart its manufacturing activities. Further details on the results of operations are provided below.”
The consent decree that Caraco signed with the FDA in September 2009 stated that the company would need to hire independent consultants who would work with the company go get the cGMP issues resolved. Once the consultants were comfortable with the new procedures and QA process then the FDA would do an inspection and make a decision no the compliance. The news by the company that it has starting calling back employees must mean that management believes it is close to getting approval from the independent consultants or has already received it. The management’s decision to start bringing back employees must mean that management is confident that it is near the end of the compliance process.
To understand the process that Caraco will have to follow for FDA compliance, let’s see what Sun Pharma said in their conference call (PDF Found Here).
“Dilip Shanghvi: As was reported by Caraco the day before yesterday, a work plan with necessary details has been submitted to the FDA. In conjunction with efforts to restart its manufacturing activity, Caraco has also begun to recall some of its employees who were part of the indefinite layoff earlier in the second quarter. Even while these efforts on resuming manufacturing are on, Caraco has transferred certain of its own products to alternate manufacturing sites in an effort to regain some revenues. Overall, Caraco intends to continue to work with the FDA to effectively resolve the remaining concerns. At Sun Pharma, we are supportive of these efforts being made by Caraco.”
So it might seem contradictory that Caraco has started recalling employees and transferring certain products to other manufacturing sites, but it is not. Management has smartly protected the company from any delay from the FDA side by taking steps to resume production at different sites.
“Dilip Shanghvi: Caraco will guide at a point when they are coming back to market. It is all linked with their revalidating and their coming back in compliance with GMP. Also FDA coming back and inspecting them. So parts of the activities are in the hands of the company, part of the issue is linked with FDA’s ability to come and inspect the plant for recertification.”
Clearly, management is doing its part to protect shareholder value… while the company has no control over the timing of FDA inspections or how low it will take to get compliance, management has done what it needs to do to ensure the company is at least generating some cash while it waits out the current storm.
Currently the company has a $175 million market cap. It has $16 million in debt and $77 million in cash. So you can buy the entire company for $114 million. In return you get over $40 million PP&E, a company with over 27 ANDA approvals pending, a company with access to big pharma type R&D abilities, a company making around $30 million in
free cash flow, and growing in the 20% range.
We believe the company is worth a large multiple of its current price. For a company making you $30 million in cash and growing at a 20% clip, let’s put a 15x multiple on it. That will get us to a $450 million market cap, a 2.5x return from current price.
With that said, we think the above estimate is extremely conservative. Specifically because, when you study the company’s operational leverage, you realize that almost all of the growth in gross profits hits the bottom line. CPD is a pharma company, but its important to keep in mind that its fundamentals are more similar to a technology company than a traditional pharma business. The major reason for this is the different type of revenue streams the company has and its unique relationship with Sun Pharma.
Again, we believe the company is worth substantially more than the current price (likely north of $450 million in just a few years time). The company currently has around 27 drugs pending FDA approval. Also, the company has distribution rights to certain Sun Pharma ANDAs, the new 25 drug manufacturing agreement with a Sun Pharma subsidiary, taking over Forest Labs’ generic arm, and management has taken on $18M of debt for an acquisition. So the growth pipeline for this company is extremely compelling. If the company delivers on 15-20% growth – and due to the mentioned initiatives such growth shouldn’t be a problem – we can easily see a 4-6x return in 3-5 years.
In conclusion, Caraco represents a very compelling short-term and long-term investment investment opportunity in our opinion. In the next 6-12 months, the FDA compliance creates a catalyst based investment opportunity. In the next 3-5 years, if management delivers on the growth potential we can easily see a 4-6x return based on current market price.