Garpy health care ldea - MYL

Growth at a reasonable price in healthcare – Mylan on the comeback trail
By Allen Phatimer

Thinking about ideas that are somewhat countercyclical in nature but also have a good chance of support from industry specific trends and/or company specific dynamics which can yield cash flow and earnings acceleration lead to me like Mylan (MYL).  I view this as an out of favor name in an out of favor sector; a contrarian idea which would effectively surprise positively if they simply met guidance or a consensus) of non-belief) below management's guidance.  Expectations are very low in my opinion, and its understandable given the history; but Mylan suddenly appears positioned to beat expectations and gets no credit for that prospect.  Management sounds very confident regarding their financial prospects yet the street says single digit forward multiple until Mylan shows us the money.

The history for those of you that don't know is that a couple of years ago the company had improving new product momentum, was valued cheaply and primed to fly as they blew out estimates for the first time in a while.  Instead of leaving well enough alone, they did a pharmaceutical ingredient co. acquisition which made sense strategically and was bought at an arguably fair price but then quickly got into a bidding war for Merck KG's generic drug business.  Merck KG was more than twice their size and also made sense from a longer run strategic perspective as it gave MYL access to new faster growing markets in Europe and Asia and effectively would make them a global player which would leverage the new ingredients, lower cost manufacturing capacity and distribution.

It could have been brilliant; if only Mylan didn't over pay.  As it turned out Mylan got into a biding war with all the big global generic guys AND about 4 private equity investors.  The bidding got too rich for the publicly traded companies involved and private equity investors gave up shortly thereafter. MYL won and went from a company trading at 9 times earnings with sales momentum and operating leverage positioned to beat estimates for the first time in years, to one paying a big premium and diluting the hell out of its shareholders as they financed the deal (with stock and debt) after they stock went down significantly.

The company has since put up weak results and guided down a couple of times but now guides to significant improvement which no one seems to believe.  That now appears poised to change. Earnings out a couple of weeks ago look much better than expected and MYL reaffirmed guidance for both 2009 and 2010. Sales, margins and net income were substantially better than expected and synergy potential still lies ahead of them.  Management said they've realized $100M of the $300M in synergies they plan and expressed confidence that they achieve their target of $300M by year end 2010.

Furthermore, the co. detailed the pipeline; which includes 93 ANDAs related to about $65B in branded sales of which 22 are potential first to file opportunities related to roughly $12B in branded sales. First to file opportunities are a boon to generics, where companies have 180 day exclusivity and not only price much higher than competitors that join the fray on day 181; but also work to cement sales relationships in these new products before competition arrives.

The pipeline is key because new product momentum is what will offset pricing pressure which is a fact of life for generics.  In the quarter recently reported Mylan posted better sales and margins, mainly due to a improved mix of higher margin U.S. sales which more than offset pricing pressure in Europe and to a lesser extent Asia.  Mylan is very well positioned on this front; and the share price gets no credit for this in my opinion

Another key part of the investment case is that utilization increases at the same time that a lot more drugs go off patent in the next 3 years.  In 2009, 2010 and 2011, more branded drugs will lose patent protection than ever before.  And as more people across the globe have access to cheaper medicines and payers and governments push moves to generic alternatives to cut costs, utilization can also grow.  So this is really a long term investment call.

The idea is to be there in front of the potentially big earnings momentum in 2010 and 2011, when Mylan is launching new blockbuster generics and fully leveraging its leaner cost structure.  If spending is kept in check, free cash flow should grow nicely over that time and can really explode in 2011.   The few bulls in the name talk about opportunities in biologics although that can be another significant growth driver post the patent expiration bolus in 2011; that's too far out and too uncertain to hang your hat on in my opinion.

The company is looking for mid to high single digit revenue growth for both 2009 and 2010 and if you conservatively extrapolate what the co. expects in terms of R&D investment and SG&A, you get to roughly 200 basis points of operating margin expansion in 09' vs. 08' and another 100 basis points in 2010.  That translates into huge operating leverage as pre-tax earnings grow 40-50% in 09' and another 20% in 2010.  If you assume a constant 34% tax rate, you can get to $1 in 2009 and $1.40 to $1.50 in 2010.

It's worth noting that management guides to a range of $0.90-$1.10 in 2009 and $1.50-$1.70 in 2010. So, good execution and a modicum of pipeline success can easily make EPS $1.50-$1.60 or more in 2010.  If Mylan can do $1.50, I think its reasonable to expect a market multiple by year end 2010 (let's assume a conservative 12X's) and that gets you to $18.  That's a double ladies and gents.

On the flip side, there's little reason to expect any less than 10 times on a $1.40 number if execution is solid, so the margin of safety is substantial.  If on the other hand, estimates are topped and the number is closer to $1.60, investors are apt to get really excited and bid the multiple to 13 or 14, which would get you north of $20/share.

On a shorter term basis, I think a couple of marginal earnings beats can get this name 11 times the $1 expected in 2009.  That would amount to a 20%+ gain from here in the next 6 months and the street would likely look to roll that target multiple forward to a $1.40ish number for 2010 – which would get you north of $15 a year from now.

So the net-net here is that you have a decent company in an out of favor sector and industry that has stumbled and appears to be regaining traction at a time when secular trends are poised to improve and mitigate cyclical pressures in the years ahead.  Sentiment is bearish, management has a credibility issue and valuation at 9 times 2009 EPS reflects. Several things can go right in the next 2 years and MYL can standout as a margin and earnings growth story in a world where few exist.  Estimates appear to have stabilized, expectations are positioned to bottom and valuation multiple have minimal risk in my view, IF Mylan can simply hit its targets.

Meanwhile, huge amounts of patent expirations in the industry, a record number of first to file opportunities and yet to be realized merger synergies are reasons to be optimistic that Mylan can deliver better results. Some might question its balance sheet as the company put a lot of debt on to pay for the Merck KG assets.  Fair concern but the cash flow is relatively visible and stable and the interest expenses well covered in even a very bearish scenario for profitability in 2009 and 2010.  Thus I think the debt service burden very manageable and if the balance sheet is delivered faster than expected, which is quite possible; it would add additional support to EPS growth in 2010.

The shares are well off their recent lows and thus apt to give a little back in the days ahead. So you have time to build a position by buying a little here and adding on any meaningful pullback.  The recent trading action and very short run chart pattern seems to indicate that the shares are under accumulation so I doubt a big pullback is coming.  I'd expect pullback to find support in the $8.40 to $8.50 area and better support near $8.  If your approach requires one, I'd suggest using stop at $7.80.  If you can take a longer term view, I would look to buy a third here and third at $8 if it ever gets there and another third at $7 if that happened, all else was equal.  At an average cost of $8, I think you'd be getting well compensated for the risk and would stand to do very well if anything went right.