Even With Growth Opportunities Ahead, Is Hospira Overvalued?

Leading specialty injectables and infusion pump manufacturer Hospira (NYSE: HSP  ) has suffered greatly from largely self-inflicted wounds over the past couple of years. A lackadaisical approach to proper plant management has led to numerous FDA warning letters at key plants and a shipment freeze on the company's pumps. Yet, Hospira remains the largest player in an industry that has attractive gross margins, significant barriers to entry, and frequent supply shortages.

Hospira seems to be on the road back, and seems to be taking seriously both the need to comply with the FDA regulations and the need to augment its long-term growth potential. The problem is that it looks like Wall Street is already many steps down that road in terms of rewarding the company with a robust valuation.

Specialty injectables can offer growth and value
Hospira is the largest player in the specialty injectables market, a sub-sector of the generics market. With almost one-third of the market by volume, Hospira is considerably larger than Fresenius, Hikma, and Pfizer, though the shares shift a bit when you consider the value of the products.

Unlike the "regular" generics market, injectables are harder to manufacture, and that constitutes a meaningful barrier to entry. It is not uncommon, then, for companies like Hospira, Fresenius, or Hikma to have 50%-plus market share in particular products, with appealing gross margins. It is also not uncommon for there to be significant shortages; with relatively few manufacturers for any given product, manufacturing problems at one or two companies can create shortages, and there have been upwards of 100 shortages per year in injectables in the U.S. in recent years.

As of the last analyst day, Hospira has a pipeline of almost 80 molecules with branded sales value of $17 billion, with about 80% of these expected to launch over the next five years. Hospira is also looking to take this expertise and apply it to the manufacture of biosimilars – generic versions of biological products like antibodies. Through a partnership with Celltrion, Hospira is looking to develop biosimilar versions for major drugs like Remicade.

The pump market is appealing, but Hospira must do better
With CareFusion (NYSE: CFN  ) , Baxter (NYSE: BAX  ) , and B. Braun, Hospira is a major player in the infusion oligopoly. Management believes that Hospira has about 25% of the pump market (CareFusion is likely the leader with around 40%, and Baxter seems to be in the high 20%'s), a market where five-year replacement cycles are complemented with the sale of high-margin consumables. With Baxter, Hospira is also one of the leading sellers of IV solutions, a synergistic business for both of these pump manufacturers.

CareFusion and Baxter have been benefiting from Hospira's self-inflicted manufacturing and management issues. Not only did the company face a recall of its Symbiq pump some time ago, problems at its Lake Forest and Costa Rica plants led to shipment holds on the company's pumps (basically taking them out of the market). Hospira has been trying to transition customers to its Sapphire pump (manufactured by a different company), and is looking forward to sales of the newer Plum A+ and Plum 360 pumps down the line, but these manufacturing issues must be resolved.

The good news for Hospira is that quality control issues are seemingly endemic to the infusion pump business. With that, CareFusion and Baxter have gained share on Hospira due to these issues, but history says that they will have to be careful not to run into their own problems down the line.

Major FDA issues still not entirely resolved
Most large companies in the med-tech or pharmaceutical space eventually run afoul of the FDA, but Hospira has had uncommonly serious problems. The FDA made repeat observations of violations at the company's Rocky Mount, NC (responsible for about one-quarter of the company's injectables volume) and Austin, TX plants, citing "serious, systemic" problems.

It looks like the company is on the back half of this issue, though, as the FDA recently changed the status of the Rocky Mount and Austin plants to "Voluntary Action Indicated", meaning that they have not been cleared (FDA reinspections should occur around midyear), but the company can now get FDA approvals for new products manufactured at those plants.

Looking to a better future
Hospira has had a bad run of late in terms of financial performance, but the past doesn't have to be indicative of the future. There is no obvious reason as to why the company cannot achieve management's goal of long-term gross margins of 45%, nor continue to reap significant growth from its injectables business through generic launches and biosimilars. The infusion/medication management business is not likely to be high-growth (though there could be some "catch up" share gains), but it should produce consistent and attractive cash flow.

With that, an estimate of 6% long-term revenue growth seems appropriate, with free cash flow margins rising back into the low teens (and 10% free cash flow margins in 2018 a real possibility).

The bottom line
All of the above is fine, but the Street has already embraced the Hospira comeback story. Even if you look past the company's FDA issues and give it an advantaged discount rate to reflect its market position in injectables and pumps, it takes high single-digit revenue growth expectations and strong improvements in free cash flow generation just to get to today's price. Biosimilars may indeed unlock multibillion dollar growth opportunities, but a lot of that seems to be in the stock already.

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