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Friday, January 29, 2016

Looking at Depomed's Valuation

I continue to be long shares of Depomed, Inc. (DEPO) despite the significant selloff in the stock year-to-date. Depomed stock is down 18.2% YTD vs. the S&P-500 down 7.6%. That's a steep decline for a profitable specialty pharmaceutical company with solid fundamentals. For reference, the SPDR Biotech ETF (XBI) is down 29.7% and the iShares Nasdaq Biotechnology Index (IBB) is down 23.3% YTD. It is clearly "risk-off" in the healthcare sector right now. High-risk biotech stocks are getting destroyed as investors flee the space. For the record, Depomed is not a biotech stock. It's clearly a specialty pharmaceutical company, and they are profitable. Nevertheless, that's not helping keep the name above water so far in 2016.

I cannot predict when investors will return to these types of names. That being said, as an analyst and investor in this industry, I can still take a look at the valuation of Depomed and provide insight into why I believe the shares are attractive for long-term investors.

The Fundamentals

Below is a snap-shot of my revenue model for Depomed. My numbers are based on my own forecasting using prescription data and historical trends for the company's key products. Based on the consensus as reported by Capital-IQ, my numbers are fairly consistent with sell-side analysts that publish on the stock. For example, the consensus revenue estimated for 2015 is $342.5 million; I model $344.1 million. For 2016, the consensus according to Capital-IQ is $504.4 million; I model $501.0 million. So as investors can see, I'm fairly consistent with the eight sell-side analysts that cover the stock for the big investment banks. I do not know if that is a good thing or a bad thing, but I figured it was worth noting!


The obvious driver of the top-line is Nucynta and Nucynta ER. I see the product generating $305 million of the projected $501 million in revenues for 2016. As Nucynta and Nucynta ER goes, so goes Depomed's stock; or so one would believe. In this regard, it is interesting to note that Nucynta ER total prescriptions grew by 20% year-over-year in December 2015 alone. This impressive number follows 22% TRx volume growth in November and 14% TRx volume growth in October 2015 (source: slide 11 of the January 2015 Investor Presentation).

On a sales standpoint, the numbers are even better because the company raised the price by 40% in April 2015. Despite the price increase, the product is gaining steady market share within the long-acting opioid market, clearly pulling prescriptions from products such as OxyContin ER and Opana ER. I think we will see Depomed report strong fourth quarter 2015 results when the company reports earnings in February 2016.

Speaking of earnings, Depomed has a history of beating estimates. The chart below shows the reported revenue line surprise for Depomed vs. the consensus per Zacks Investment Research. Green arrows represent a "beat" to the consensus revenue number, whereas red arrows represent a miss. The size of the arrow is relative to the size of the beat or miss. Notice, the company has a good track record of beating consensus for the top-line, having beat estimates eight of the last nine quarters.

 

That does not necessary mean the trend will continue, but Depomed is a company that gives full year guidance and right now estimates for 2015 are within the guided range. I believe that shows good credibility for management. As such, I'm fairly comfortable with my estimate for $500+ million in revenue at Depomed for 2016.

I'm also fairly comfortable with the intellectual property of company's key revenue generating assets. Depomed has an impeccable track record of protecting its IP and all products are under patent protection to at least 2022. They key driver of the top-line, Nucynta and Nucynta ER, is under patent protection until 2028 (update: February 8, 2016 - favorable Markman ruling). I pulled the slide below from the January 2016 investor presentation (slide 21).


Below is a snap-shot of my full income statement for Depomed. As noted above, these are my estimates using my own forecasts for gross margin, SG&A, R&D, interest expense, etc... For 2015, my Adjusted EBITDA number is $112.1 million, which is consistent with the company's guidance for Adjusted EBITDA between $108 and $116 million as provided to investors on November 9, 2015.


For 2016, I see the Adjusted EBITDA number increasing to $205.4 million. This is an EBITDA margin of 41%, which shows a slight improvement over the reported margin as of the third quarter 2015. It is logical to believe that Depomed will continue to see margin expansion as Nucynta and Nucynta ER ramp.

On July 31, 2015, CEO Jim Schoeneck stated on the company's conference call to discuss financial results for the second quarter ending June 30, 2015, "We anticipate reaching 50% EBITDA and 40% operating margins, ratios found in big-cap spec pharma companies within the next two years." Again, I have found management to be highly credible when they provide this sort of guidance. Note the chart below shows how the company has done reporting EPS vs. Street consensus estimates.


Since Jim Schoeneck joined Depomed in April 2011, the company has beat consensus EPS estimates in 13 of the last 17 full quarters he has been the CEO. Again, I find him to be highly credible and I find the current guidance on where EBITDA margins are headed as very reliable. For 2017, I think the company will report Adjusted EBITDA of $296.8 million.

What's It Worth?

The key question for investors is then - What is that worth on a peer-valuation basis?

I feel very comfortable with my revenue and EBITDA numbers for 2016. I model $501 million in revenue and $205 million in Adjusted EBITDA. The table below came from a January 4, 2016, report by Morgan Stanley. It shows the current valuation metrics for the U.S. specialty pharmaceutical peer group, a group which Depomed is clearly a part of and included on the list by Morgan Stanley (data from Thomson Reuters).


These are forward multiples based on Morgan Stanley and consensus estimates for 2016 and 2017. The range for 2016 Enterprise Value (EV) / EBITDA multiple is quite wide, and thus I believe the Median number makes the most sense to use for comparable analysis. As investors can see from the table above, peer-group analysis of the U.S. specialty pharmaceutical industry suggests that Depomed should trade with an EV of 5.0x revenues and 10.6x EBITDA. For Depomed, this would equate to:

     - EV / Sales >> $501 million x. 5.0 = $2,505 million
     - EV / EBITDA >> $205 x 10.6 = $2,173 million

The fact that the EV / EBITDA methodology yields a valuation lower than the EV / Sales methodology is not surprising because Depomed's Adjusted EBITDA margin of 41% (my estimate) for 2016 is below the peer-group average. Based on the methodology, the average specialty pharmaceutical company has an EBITDA margin of 47%. Again, recall the comment from CEO Jim Schoeneck back in July 2015 where he states that he believes Depomed will obtain near 50% Adjusted EBITDA margins, consistent with the larger peer group, in two years. So at this stage, Depomed is not as "profitable" as some of its peers, but clearly heading in that direction as Adjusted EBITDA margin has been on a steady rise.

The other thing investors should understand is that revenue growth at Depomed has been impressive. One could clearly argue for paying less for a speciality pharmaceutical company with slow or lackluster growth. However, as seen in slide 6 of the January 2016 investor presentation, the CAGR of the top-line is 132% since 2012. For 2016, I model an increase in revenues of 46%. That is superior to the peer-group average from the Morgan Stanley table above of only 32%. One could argue it makes sense to actually pay more for Depomed than its peers; after all, Depomed is growing its top-line at 1.4x the rate of the average company in specialty pharma.


All that being said, in an effort to be conservative, I'll take the average EV using the two methods noted above. That equates to an EV of $2,340 million. The formula for EV is:

EV = Market Cap of Equity + Oustanding Debt - Cash

Using that formula, we can now back into what the market capitalization of Depomed's equity is worth based on comparable peer-valuation analysis because we know both the debt and cash position as of September 30, 2015. As reported in the Form 10K on November 9, 2015, the company has outstanding debt of $802.6 million ($563.0 million in Senior Notes and $239.6 million in Convertible Notes) and cash and marketable securities of $172.5 million. Using these numbers, the market value of Depomed's equity should be approximately $1,710 million.

As of November 9, 2015, the number of shares outstanding (basic) is 60.5 million. Dividing $1,710 million by 60.5 million equates to a stock price of $28.25 per share.

Alternative Approaches

There are several "next logical questions" that one should ask following the analysis above. Firstly, $239.6 million of Depomed's debt is convertible into common stock. If we remove the debt from the balance sheet and add in the common stock equivalents of 17.9 million for the convert, the target price adjusts to $24.85 per share - still a nice return from today.

If we assume no margin expansion in 2016 to 41% and just use the 36.5% reported in the third quarter 2015, the target price would drop to $26.32 per share before the convert and $23.35 per share after the dilution from the convert. Again, not bad.

Finally, if we are truly entering a long-term bear market for healthcare stocks, then we should use the bottom of the historical range for multiples on EBITDA. The chart below shows that EV/EBITDA range for specialty pharma names over the past five years. As investors can see, the current 13x mean is well above the recent historic range (low of 6x in 2010). Let's face it, the past four to five years has been pretty kind to healthcare investors. There has been significant margin expansion on these names and if the "good times" are truly over, we are going back down to rock-bottom multiples.


If we apply a rock-bottom multiple of 6x EBITDA to my 2016 estimated for Depomed of $205 million, we arrive at an EV of only $1,230 million. This equates to a stock price of $10.00 per share. That would seem to be the valuation floor, all else being equal, on Depomed.

Current stock price: $14.85 per share.
Upside to current target of $28.25 per share = 90%
Downside to valuation floor of $10.00 = 32%

I am long DEPO at $16.35 per share. 

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2 comments:

  1. Thanks for a well considered analysis of Depomed. I do have a question. Your valuation adjustment for the conversion of the convertible notes to common stock appears to use the initial conversion rate, and does not account for the adjustment to the initial rate based on the conversion date and the stock price at conversion, as detailed in the conversion table. Have you overlooked this?

    ReplyDelete