Taro Pharmaceutical Industries last Thursday reported a 15% decline in sales and a 20% drop in gross profits, but its stock still rose by 6% on the two subsequent trading days and by another 1.1% on Tuesday. There is an explanation for the stock’s bizarre behavior, but what is harder to comprehend is that based on its current share price, the company is now worth $6.3 billion. After all, it’s the same company that was on the verge of liquidation in 2007 because it didn’t have the funds to pay $15 million owned to bondholders and because the controlling shareholders at the time refused to shell out the necessary money from their own pockets, while Bank Leumi and Bank Hapoalim were refusing to increase Taro’s line of credit.
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Taro was mired at the time in prolonged efforts to avoid restating its financial results, and was facing an external audit ordered by the U.S. Security and Exchange Commission related to the circumstances leading up to the restatement of its financial statements. The wariness of the Israeli banks was therefore not altogether out of line, but nonetheless the banks’ stance and the shortsightedness of Taro chairman Barrie Levitt created a once-in-a-lifetime opportunity for Dilip Shanghvi, the controlling shareholder of the Indian firm Sun Pharma.
Sun, which is based in Mumbai, injected $40 million into Taro in exchange for 6.7 million shares of Taro stock at $6 per share – with an option to buy the shares of the Levitt and Moros families, who controlled Taro, at $7.75 a share. The injection of the additional funds did the trick and Taro quickly returned to the high levels of profitability it had enjoyed before the crisis. At that point, the Levitts and Moroses attempted to avoid having to honor the stock option agreement with Sun. After a three-year legal battle, however, they turned over the controlling interest to Shanghvi for $37 million. All told, Sun spent $273 million for its control of Taro.
Seven years later, Sun’s stake is worth $4 billion, representing about 15% of the value of Sun itself.
Sun’s $3.2b acquisition
Sun is India’s largest drug maker by market value. It is in the process of gaining regulatory approvals for its $3.2 billion acquisition of loss-making rival Ranbaxy Laboratories from Japan’s Daiichi Sankyo and expects to close the deal by December. Taro was founded in Israel in 1950 and has production facilities in the Haifa Bay area, where its Israeli headquarters are also located.
Part of the explanation for Taro’s astounding revival can be found in the financial results the company released last weekend. Taro, which is a leader particularly in the skin medication field, reported second quarter revenues of $130 million, a 15% drop from the same quarter last year, and gross profits of $85 million, down 20% from a year earlier. Although the company’s fortunes had seemingly dimmed over the year, the revenue decline simply reflects the wild market realities that Taro faces, which have enabled Sun to derive the maximum benefit from the rather dull product lineup that it got when it purchased Taro for a bargain basement price.
As Kal Sundaram, Taro’s current CEO explains it, the drop in sales resulted from provisions for discounts to the company’s largest customers in the second quarter. If it has not been for those provisions, sales would have grown by 18% in the quarter and gross profits would have increased by 25%, in a better reflection of the company’s true condition. Taro was required to more than triple the amount it set aside for discounts because based on agreements that it has with drug store chains, drug wholesalers and major drug procurement companies in the United States, it provides them with a discount of an agreed upon rate off the list price. Therefore if Taro decides to institute major increases in its list price of a drug, it has to correspondingly increase the provision for discounts to its major American clients.
As CEO Sundaram noted, the positive impact on the company’s drug price increases will be felt in the third quarter of this year while the negative effects of the provision for the discounts was already accounted for in the second quarter. The fact that Taro, which reported $736 million in revenues over the past 12 months, increased the amount it set aside for customer discounts by $55 million in one quarter is an indication of the major extent to which the company increased its prices. Drug industry sources note that Taro has quadrupled the price of some of its drugs in recent years and even the price of one of its long-standing stable of offerings, Warfarin, which is the generic form of Coumadin, a blood-thinning medication, was increased by 40%.
Taro’s ability to raise prices to such an extent may seem surprising considering the reputation that the generic drug market has for stiff competition. In its financial reports, the company in fact mentions the major competition that it faces, but industry sources and the data from Taro itself paint a different picture.
Taro’s dominating influence
Taro does business in a small and relatively tranquil niche of the generic drug market. It has a dominating influence in the generic market for drugs for the treatment of skin diseases, along with companies such as Fugera, which was acquired by Novartis in May of 2012 for $1.5 billion, and Perrigo and the Indian company Glenmark Pharmaceuticals, along with other companies such as Mylan Laboratories and Teva Pharmaceutical Industries, whose skin medication sales are much smaller than Taro’s.
The domination of the skin medication market by a limited number of players, along with the fact that the American market for the products is considered to small to entice most of the world’s major pharmaceutical companies to try their hand in the sector, make it possible for companies in this niche to raise prices whenever the opportunity presents itself. One example of such a moment is when supplies decline as one of the players encounters a quality control problem with the U.S. Food and Drug Administration. This also lowers competition for public tenders for medications.
For its fiscal year ending in March of this year, Taro reported a $88 million increase in sales, a 13% jump compared to the year before. In large measure this was the result of price increases on eight of its generic products in the United States, which boosted sales by $89 million. For the year 2013, Taro had a 76.4% gross profit margin, compared to Teva’s 41.6% profit margin in the generic sector in the second quarter of this year.
In fact, Taro’s profitability from ointments, creams and sprays, most of which have been around for a long time, is not that disparate from Teva’s 89.5% profit margin from its sale of Copaxone, its proprietary drug for the treatment of multiple sclerosis. It is therefore also not such a surprise that the new head of Teva’s generic division, Sigurdur Olafsson, made mention of the skin medication market as one of the sectors where Teva needs to get a bigger foothold.