Can Perrigo Company PLC Continue Its Bull Run?

There's a pretty good chance that if you use store-brand OTC consumer health products, you have a Perrigo (NYSE: PRGO  ) product in your bathroom right now. Perrigo hasn't completely eschewed the prescription-based generic drug business that build companies like Teva (NYSE: TEVA  ) , but it has focused a great deal of its time and energy on ruling the store-brand OTC market. That business now offers pretty solid cash flow and returns, with plenty of growth opportunity in areas like diabetes and pet care. Perrigo doesn't exactly carry a "store-brand" multiple today, but these shares could still offer some upside as the company looks forward to further OTC launches, additional M&A, and growth in the nutrition and overseas markets.

The strongest hand in a growing market
Store brands have become a win-win-win for at least three of the parties involved. Shoppers who don't care if the bottle says "Tylenol" or "Zyrtec" can save 20% or more on the bottle labeled "Kroger;" Kroger can generate meaningfully better margins on these sales, and Perrigo wins through scale and market share gains. So far, it's been working; as store brand penetration has moved from 20%+ to over one-third over the last decade, Perrigo has leveraged that into 8% organic revenue growth with good margin leverage and cash flow generation.

Perrigo's market share in the store brand category varies with the product type, but it is likely around 60% to 70% overall (and well above 70% in certain categories.) Generic companies like Teva can and do compete here, but they lack the scale, particularly distribution, to compete as effectively with the revenue splits that the store customers want and profitably offer the same sort of customization options.In fact, Teva and Perrigo partner from time to time OTC store-brand generics.

Perrigo likewise competes with branded OTC businesses like Johnson & Johnson (NYSE: JNJ  ) and Merck, many of which invest hundreds of millions of dollars in building brands and brand value. Johnson & Johnson earned $4 billion in revenue from its OTC business in 2013 (out of more than $14.6 billion in consumer segment sales) from products like Tylenol, Sudafed, Motrin, and Zyrtec, even though store brands are available for almost all of these products. Prior to the recall debacle a few years back, Tylenol still held dominant share in its category (70%+) despite premium pricing and no added benefits.

Looking ahead, this business looks quite promising for Perrigo. I don't believe that the trend toward store brand substitution is going to change, nor do I see companies like Teva rearranging their models from a focus on prescription generics to OTCs. It also looks as though the FDA is increasingly willing to consider focusing some attention on prescription-to-OTC conversions. Sanofi's Nasacort was cleared relatively recently for OTC sales, and sentiment is building that the FDA may clear statins (like Pfizer's Lipitor), other nasal sprays, and drugs for BPH and OAB in the coming years. In some cases there will be obstacles to the market – Pfizer's "actual use" study of Lipitor should grant them a three-year window of exclusivity if it goes OTC – but OTC Lipitor could still mean 5% incremental sales in 2019 for Perrigo.

Not ignoring generics, but being selective
Perrigo has prioritized OTC consumer health, and has traded some margin leverage in the process as the Rx business generates operating margins of more than 40% compared to 17% in OTC consumer health. Even so, Perrigo has a credible business in prescription generics.

Instead of being all things to all people, and dealing with the scale of Teva, Novartis, and Actavis day-in and day-out, Perrigo has chosen to specialize. Perrigo is the market leader in topical formulation generics, and has top-three share in the overwhelming majority of its products. Novartis is a close second in this topical segment, but Perrigo is more than twice as large as Teva and three times as large as Actavis. Future business expansion efforts are likely to be aimed at maintaining this sort of focus, and simply broadening into closely related adjacent markets.

Nutritionals could be the next big growth opportunity
Perrigo's nutritionals business is similar in principle to the OTC consumer health business: Perrigo teams with stores to offer customized store-brand products in the infant formula space. Store-brand formula has much less share of the market than OTC medicines, somewhere in the neighborhood of 10% to 15%, but Perrigo has leading share here. Given the cost of formula, this would seem to be a market poised for growth as squeezed consumers look to make shopping dollars go further.

Leveraging Elan for lower taxes and greater options
The multibillion-dollar acquisition of Elan brought multiple benefits to Perrigo. First and foremost, the deal allowed Perrigo to do a tax inversion that will see profits channeled through the lower-tax domicile of Ireland, likely lowering the effective tax rate by 10% or more. Second, Elan brought with it a stream of royalties tied to the MS drug Tysabri (marketed by Biogen Idec.) Perrigo has already received multiple offers to acquire this royalty stream, but management has declined as it would be a value-reducing move at this point. I would estimate that Perrigo could sell that royalty stream for around $7 billion (depending upon the structure of the deal), and that's a valuable source of future funds when the moment arrives.

To that end, I believe that the Elan deal bought some added options for Perrigo down the line. The company can leverage the deal to expand operations in areas like Europe and monetize that royalty stream to fund the right deal. Expect management to be picky; the company currently earns a good spread on its cost of capital, and there aren't an abundance of deals out there that will match that.

The bottom line
I do not expect Perrigo to become deal-happy, but I do believe that there are enough opportunities to grow the business through M&A such that deals will continue to add incremental growth. I look for the company to continue producing organic revenue growth in the neighborhood of 7%, with M&A adding another 3% to that over the long term. With added scale and the tax inversion, I look for Perrigo's FCF margins to climb into the high 20%'s over time, fueling FCF growth of almost 20%.

With those cash flows, a fair value of $169 seems reasonable today. It's a little surprising to see a stock with high trailing multiples still offering double-digit undervaluation, but such is the value of leveraging the Elan deal and added scale. Given the solid, predictable base in store brand OTC consumer products, Perrigo still looks like a good risk/reward opportunity even after a stretch of market-beating performance.

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