Perrigo (NASDAQ:PRGO) is the clear U.S. leader in making private-label OTC drugs for retailers. It has about 65% market share in the business of making store-branded OTC products that relieve coughs, colds, allergies, pain, stomach aches, and even the urge to smoke. The company's relationship with Wal-Mart (NYSE:WMT), which accounted for 28% of fiscal 2004 sales, buttresses this market share, but Perrigo has a broad array of additional major customers including Walgreen (NYSE:WAG), CVS (NYSE:CVS), Kroger (NYSE:KR), and Albertson's (NYSE:ABS).

Successfully operating in the private-label business is quite challenging, requiring superb manufacturing and logistics. While Advil is usually sold in the same product pack across the nation, Perrigo has to pack Wal-Mart's ibuprofen in a different package than Walgreen's. In addition, Kroger might request Perrigo make a 100-tablet package, while Albertson's prefers selling a 120-count pack. Being able to cost-effectively manufacture, package, and deliver these products requires top-notch operations.

Toward the end of last decade, Perrigo had problems delivering operational excellence, and profitability suffered greatly. But under the tutelage of President and CEO Dave Gibbons, who joined the company in May 2000, the company has been able to substantially improve operations. While sales grew by only 19% between 2000 and 2004, operating earnings more than tripled as operating margins expanded from 4.4% to 11.4%. This success is attributable to focusing on the company's core business, improving efficiency, and introducing new products.

Moving into generic prescriptions
Perrigo management expects the OTC drug business to grow in the low single digits over the next few years, but generic prescription drugs are seen growing at a more substantial 7% to 10% range annually. With Perrigo's manufacturing and logistical expertise and strong relationship with retailers, management felt moving into generic prescriptions was sensible. The company began this initiative in 2003, but really jump-started it earlier in the year with the acquisition of Agis Industries, an Israeli company with an expertise in generic creams and ointments. Through this deal, Perrigo gained the infrastructure off of which it plans to build its generic pharmaceutical business, as well as a complementary private label OTC business.

While appearing to make strategic sense, this deal also complicates the operating and financial picture of Perrigo. Agis adds new business lines and substantial international operations and personnel, all of which will need to be successfully integrated, managed, and controlled. In addition, the generic drug business is notoriously volatile, with earnings boosts from new product launches followed by plunging results less than a year later as competition intensifies. Perrigo management has stated its expectation for the transaction to be neutral to fiscal 2006 earnings, but that assumes a successful integration will no hiccups and no unexpected competitive incursions. While such a clean outcome is certainly possible, the risk of a negative surprise is typically high after a merger of different organizations.

Changed financial characteristics
The Agis transaction also changed Perrigo's financial complexion. The $829 million deal, priced at about twice Agis' calendar 2004 revenue and 21 times earnings, was paid for with $419 million cash and assumed debt, as well as 22 million Perrigo shares. Due to the structure of the deal and accounting rules, the company took a huge $389 million charge for in-process research and development; balance sheet debt went from $9 million as of December 2004 to $689 million; and inventories jumped up to $301 million from $167 million. In reality, none of those line items are as bad as they appear.

The $389 million charge took a big chunk out of the company's book value, but didn't truly harm the company's value to investors. Accounting rules require companies to charge off the expected discounted cash flow of research and development projects that haven't reached feasibility. Now, if all of Agis' research activities fail, this treatment will end up being accurate. But if some of them yield viable products (which is one of the main reasons Perrigo acquired them), Perrigo will see an earnings benefit.

As to the huge jump in nominal debt, Perrigo took out a loan in Israel for $400 million at 5.025%, but put the same amount of money on deposit at a 4.9% rate (listed on the balance sheet as "Restricted Cash"). This was done to facilitate the funding of inter-company activities. The company's true consolidated net debt is only $215 million, which isn't too onerous for a company with average operating earnings and operating cash flow over the past three years (excluding Agis) of $89 million and $101 million, respectively.

In terms of the inventory number, accounting rules require Perrigo to write up Agis' inventory to expected realizable value (instead of cost), which caused this number to be boosted by about $28 million. As this inventory is sold over the next three to six months, inventory should come down by a similar amount. Perrigo will likely note this difference in its earnings releases, which is actually a legitimate exclusion for comparison's sake.

A hit to the core business
Around the time Perrigo completed the Agis acquisition, a road bump in Perrigo's core business began growing. State legislatures are becoming increasingly active in regulating the sale of the many products for cough, cold, and allergies that include pseudoephedrine, an ingredient in products that represented about 20% of Perrigo's historical sales. These products, which include both branded and generic versions of products like Sudafed, can be used as one of the raw ingredients in crystal meth labs.

Due to these regulations, many retailers have decided to adopt the most stringent regulation proposed, moving items with pseudoephedrine "behind the counter" at pharmacies. While not requiring a prescription to buy them, identification may be required and quantities purchased may be limited.

The branded companies and Perrigo are moving quickly to introduce new products that can't be converted into crystal meth. While over the longer term drug manufacturers should recover most lost business (the number of cold and allergy sufferers is unlikely to drop), this change could be disruptive to earnings over the next year or two as Perrigo has to reformulate products, manage the introduction of new products to retailers and consumers, and potentially charge off excess pseudoephedrine products.

Short-term risks, long-term opportunity
The dual challenge of integrating a major acquisition in a volatile industry (generic pharmaceuticals) and handling distribution and product shifts in 20% of the core product lines (pseudoephedrine) has scared off many investors. Perrigo's stock has fallen from $19 at the end of March down to just over $14 today. Earnings estimates have also dipped, with analysts now expecting earnings of $0.90 a share for fiscal 2005, which ended last month, and $0.98 a share for fiscal 2006. Those figures are down from $0.92 a share and $1.02 a share, respectively, 90 days ago.

These figures imply price-to-earnings (P/E) ratios of 15 times last fiscal year's estimates and 14 times this year's projections for a company with an average P/E ratio of 21.6 over the past 10 years, according to Value Line data.

As someone who often worries about negative investment surprises, I suspect that earnings estimates for this year are probably still too high. The company hasn't given earnings estimates (and likely won't until August or September), so analysts are taking a stab in the dark extrapolating historical trends. The disruption from integrating Agis and dealing with pseudoephedrine will likely cut short-term earnings more than published estimates currently anticipate. This isn't really a novel perspective -- such fear is why other investors are selling shares, trying to avoid a highly uncertain short-term outcome.

Despite concern about what might happen over the next year, I like Perrigo's long-term outlook. The company may not earn $1 next year, but I think it can do so within a couple of years. The company's strong management team has improved operations to parlay its leading market position into solid financial returns. That operating prowess should help lead to the success of the move into the generic drug business, which brings potentially higher growth and returns. In addition, as financial statements next year start to lap the accounting-distorted statements of this year, I think investors will be more comfortable with where Perrigo stands financially.

Perrigo is a great illustration of why the "buy in thirds" strategy is good. Considering that Perrigo could be very volatile in the short term, buy only a third of the position you ultimately want to own. Build out the position if the stock drops further or more clarity regarding the impact of pseudoephedrine and the Agis integration justifies a higher price. Although buying into somewhat uncertain short-term situations can be difficult to stomach, doing so will usually be highly profitable if you buy into quality companies and are patient.

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Fool contributor Warren Gump doesn't have a financial position in any company mentioned in the article. He would prefer to spend his summer on the beach rather than in hot and humid Washington, D.C.