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Three Great Unknown Stocks

Now for a drug company that's produced 20 consecutive quarters of record sales. It's amazing that the shares of Taro Pharmaceuticals (Nasdaq: TARO) have risen more than 1238% in the past five years, an honest-to-goodness thirteen-bagger! Even more incredible is the fact that the majority of the gains have occurred since September of 1998, when the shares traded at $3.88. Today, a stub of Taro will run ya about $89. Wow.

Taro Pharmaceuticals is a drug company based in Israel with operations in the U.S., Canada, and around the world. It focuses on creating generic drugs, or "copycat" drugs. When a drug company invents a new drug, they patent-protect it so that nobody else can produce the same drug. The patent expires 20 years after issuance, which on average is about three years after a drug gains Food and Drug Administration (FDA) approval and hits the market.

After expiration, any drug company can copy the formula and sell the exact same drug, often for much less than the original product. Typically, generic drugs will sell for less than half what the name brand drug sells for, even though they work exactly the same. (For more on pharmaceuticals, see our InDepth industry page.)

If you want to see generic drugs in action, go into any drugstore in the country and look at the cough syrup. Check next to Robitussin, a popular name-brand cough syrup. If you go into a local CVS(NYSE: CVS), the largest U.S. retail pharmacy chain, you'll likely find a generic version of Robitussin labeled "CVS," selling at a 25% or more discount. The colors on the package will even be the same. Drug companies like Taro will manufacture these generic drugs, stamp CVS on them, and sell them to you. Why does this work?

Why generics succeed
Large drug companies spend billions in research and development to discover and create new drugs to help people. They have huge expenses, must pass extensive FDA trials, and need to spend millions more to market the new drug. They get patent protection for 20 years, but after FDA approval, there are typically only three years or so left for them to recoup all of their costs and make a healthy profit before anyone else can compete.

Generic drug companies, on the other hand, don't need to do this. They don't have anywhere near the research costs, because the formula already exists. The approval process isn't as much of an issue because the drug has already been approved once, and you don't need to spend much to market generic drugs. All you have to do is look at the customer and tell them that the $90 prescription can be bought for $20 if they use the generic instead of the name brand. Sale made, case closed.

Generic drug companies also have at least two more things going for them. First, companies like CVS make more money on the generics than they do on name brands, so the pharmacist will always ask you if you want the generic. Second, most insurance companies want you to take a generic too because it costs them less as well. Often times, the insurer will either not cover a name brand at all, or make you pay for a good hunk of it out of your own pocket. Finally, my wife (the pharmacist) wanted me to tell everyone that it's "geneRic" not "geneTic." Please don't ask for the genetic drugs.

Priced to perfection
So why has Taro gone crazy in the last three years, and will it continue? Since August 31, 1998, Taro has achieved an annualized return of 194%, and it's been a thirteen-bagger in the last five years. Quite simply, this pace is not likely sustainable. This doesn't mean that Taro won't still achieve great returns for shareholders:  For all I know, Taro could grow its stock price 20% for the next 20 years, which would still make it one heck of an investment. But if you're looking for Taro to be a rocket ship to the moon, you might better look elsewhere -- perhaps NASA.

Why has the stock taken off so much? In addition to gaining approval for seven new generics in 2000, Taro's R&D is also producing some non-generic drug candidates. One offering, epilepsy anti-convulsant T2000, has gotten a lot of attention, though it's in the very early stages of development and by no means in the bag from a revenue standpoint. Still, non-generics can produce high profit marginsThe catch for Taro is this: If its strength is generic drugs that require little R&D, should it -- and how well can it manage -- a transition to developing its own drugs?

Earnings estimates for FY 2002 are $2.45 per share, a 161% increase from today's trailing-12-months EPS of $0.94. The stock currently trades at a steep 88 times that figure after a stunning run, and the company may have some serious spending ahead of it to fund T2000's development. Will the stock continue to roar? I'm not sure. But, I can tell you that there is not much room for error here. If anything doesn't go according to plan, momentum traders will crush this thing. Taro's an exciting company with solid results, but at a price that's not for the weak of heart.

David Forrest (TMF Bogey) does not own shares of any stocks discussed in this article, though his "for fun" paper portfolio does "own" these shares. Do you have a "for fun" portfolio? To see David's stock holdings, view his profile.

Three Great Unknown Stocks represents the opinion of one Fool and should in no way be taken as the opinion of either The Motley Fool, Inc. or the company in question, or as representative of anyone or anything other than that specific Fool's thoughts. Which can be way out there, so do your homework, and review The Motley Fool's disclosure policy

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