I’ve written before that value investors look for stocks that are priced at less than their fair value. Often, these opportunities in the stock market come around as a result of misperceptions, where the market’s concerned about an issue that, on the surface, looks scary, but is unlikely to be as significant as people fear. That’s the case with one of my favorite stocks right now, Concordia Healthcare (NYSE:CXRX) (TSE:CXR).
The Business
Concordia’s in the pharmaceutical business. Over the last few years, they’ve grown rapidly by purchasing drug portfolios from other companies and then optimizing the sales and marketing opportunities. Thus far, they’ve been successful with this strategy. They now have a broadly diversified portfolio of 1190 drugs, projected to bring in over a billion dollars of revenue this year.
Concordia has a particular focus on niche products, products with smaller markets and often off-patent. No single drug accounts for more than 10% of their revenue, and all but one are under 5%. Now, one could view this as a bad thing. After all, a bigger market means more sales. Patents mean that you can charge more for your drugs. However, there’s a flip side to that coin. Bigger markets mean more competition. Patents eventually expire, leading to huge overnight drops in revenue as generics invade.
Many of Concordia’s products don’t have those issues. Their markets are small enough it that it isn’t worth the effort for other companies to develop competing drugs. Many of their drugs have already encountered generic competition, so there’s no big drop-off in sales pending as a result of patent expiry. Consequently, their business may be more consistent and predictable than many other pharmaceutical companies.
That’s not to say that there isn’t growth. They’re planning to release 60 new drugs in the next few years, leading to revenue growth in the upper single digits. For a drug company, Concordia is still fairly small—Pfizer (NYSE:PFE), for instance, makes more revenue from a single drug than Concordia makes from its entire portfolio. So, Concordia still has room to expand.
What’s it worth?
So, roughly speaking, what’s a company like that with reliable revenue streams and reasonable growth worth? Well, they expect their earning, before extraordinary items, to be about $6.50 a year.
Suppose that I want a 14% return, and Concordia grows their earnings by 9% a year for the next decade. Then the fair value of Concordia is about $100.
And that’s interesting, because on the most recent trading day, shares closed at $26.50.
The flies in the ointment
Of course, nothing is that easy. There’s a reason why Concordia’s trading at a huge discount. Several of them, actually.
The first is Valeant (NYSE: VRX). Valeant is another Canadian drug company with a similar strategy. They’ve been buying up other pharmaceutical companies and pumping up the prices of their drugs, often to multiples of the original price. They’ve also been aggressive in their marketing tactics, to the extent that people are concerned about fraud and Valeant has had to restate its financials. It’s gotten so bad that the board is in the process of cleaning house, all the way up to the CEO.
The market’s lumped Valeant and Concordia together. They often move in lockstep. But, I don’t think they deserve to. Concordia hasn’t had any of the fraud allegations, doesn’t bump up drug prices to nearly the same extent as Valeant, hasn’t had to restate its financials, and hasn’t forced out its CEO. The market seems to view these companies as equivalent, but they aren’t.
The election
The second issue is Hillary Clinton and Martin Shkreli. Shkreli’s Turing Pharmaceuticals has played the same pricing games as Valeant, increasing drug prices by hundreds of percentage points, causing a huge backlash. Hillary’s recognized that these massive increases are a problem, and has vowed to do something about them, even mentioning Valeant directly. It isn’t good for pharmaceutical companies when regulators challenge their prices.
This is an issue for Concordia, but possibly less than might appear. First, 60% of their drug sales are outside the USA. Second, they have been far less aggressive with price increases than Valeant, so likely won’t be directly targeted. Finally, their drugs aren’t overpriced relative to the market—many of them are priced at levels less then their competition. That won’t help if the price of every drug is cut, but that sort of outcome is unlikely. Thus, I don’t consider this issue that big a deal.
My biggest concern
While the market seems to be worried about these macro issues, the thing that concerns me the most about Valeant is their debt. They owe over $3.4 billion, that’s more than three times their revenue, and over five times their EBIDTA—earnings before interest, depreciation, amortization, and taxes. Concordia has fantastic margins, but this is still a lot of debt. And half of it is floating rate, right when the Federal Reserve is starting to raise interest rates.
So, that’s not great. Debt reduces flexibility and drains cash flow. If there’s a bump in the road and debt covenants are violated, lenders can drive the company into bankruptcy, even if the company is still meeting their debt payment schedule. If Hillary does do something that causes Concordia’s revenue to tumble, that debt would give them almost no time to react. Thus, that debt increases risk.
Yet the debt seems to be manageable when you consider the consistency of Concordia’s business. People will still need their drugs, and it’s unlikely that a patent expiry or new competitor will ruin Concordia’s business overnight.
The bottom line
Thus, despite the debt, Concordia seems like a reasonable bet. The stock is extremely volatile, often moving more than 5% in a day. In light of Valeant and Hillary, this volatility is likely to continue. Nevertheless, one day Concordia’s stock is likely to disconnect from Valeant and leave these troubles behind. Thus, I think there’s a good chance that within a couple years, Concordia will be trading at twice the price or more.
Deconstruction 