(CPD) for the Portland CFA Society portfolio. Table of Contents

guiltlesscyanBiotechnology

Dec 3, 2012 (4 years and 6 months ago)

510 views


1




















Duane Allen, FIN 473, Spring 2010

A recommendation to
buy

Caraco Pharmaceutical
Laboratories
, LTD.

(CPD) for

the Portland CFA Society
portfolio.











2

Table of
Contents:













page

Executive Summary






1

Macroeconomic Analysis





2

Industry Analysis







3
-
5

Company Background






6
-
7

Business Model







7
-
12


Products
and

Markets





7
-
9


Production and Distribution




9


Life Cycle Analysis






10



Competitive Analysis





11
-
12

SWOT Analysis







13
-
14

Catalysts









15

Summary of Qualitative Findings




16

Financials








17
-
19

Discounted Cash Flow Valuation




20
-
25

Sensitivity Analysis


and Discussion of DCF


26

Analysts’ Opinion







27


Recommendation







28

1


Executive Summary

52
-
Wk. Range




$1.75

$6.94

Trailing 12
-
Month EPS



-
$
0.22

Price/Sales (ttm)




1.06

Price/Book


1.65

Current Ratio

1.63

Common Shares

(M)


39

Market Capitalization (
M
)


$
236

Institutional Ownership (%)

15.4

Dividend Rate/Share


N/A

Total Cash per Share


1.96

Beta




1.95

Qtrly
.

Revenue Growth (yoy)
-
6.7%

Credit Rating



CC (calculated)




Cara
co Pharmaceutical Laboratories, LTD
(CPD)
is engaged in the manufacturing,
distribution, and marketing of over
-
the
-
counter and prescription generic
pharmaceuticals. It is based in Detroit, MI. Caraco is one
of the f
ew smaller (market cap
~ 236 M) manufacturers of generic pharmaceuticals and is a subsidiary of Sun
Pharmaceuticals, LTD., the 5
th

largest pharmaceutical manufacturer in India. During
200
9

the
FDA
cited Caraco for violation

of good manufacturing practices

and the firm
voluntarily recalled $4.7 million worth of products
.
This led to a several fold drop in the
stock price of the company.
Several features of

the current market conditions make
CPD
an
attractive
addition to

the Portfolio.

1.

Production
problems
s
hould soon be

corrected
, but the market has not
appreciated this. Revenue is

anticipated to recover in 2011.

2.

T
he new healthcare legislation strongly favor
s

generic drugs
.

3.

Caraco, in its depressed state, is a potential acquisition target.

4.

Caraco is support
ed by a large, well
-
funded parent company.

5.

Sales remain strong, despite
the
recall.

6.

CPD r
ecently obtained FDA approval for generic Eloxatin,
which has
annual sales of
$
1.3 Billion in the US.

Risks for CPD that threaten to undermine its future grow are:

1.

Lit
igation over recall

2.

Price erosion due to larger competitors

3.

Undisclosed/undiscovered manufacturing problems

Catalysts for growth include aging populations,
demand
-
inelastic products, and
the favorable outcome of healthcare legislation.

CPD is a

slightly
distressed

stock that appears to
be

the only under
-
priced firm in
the generic pharmaceutical industry. My current free cash
-
flow valuation obtains a value
of $1
6
.
51

with a very conservative, low
-
growth assumption. This target price is
significantly higher
than the current market price of $6.05. Consequently, I recommend
that the PSU PSFA portfolio
BUY

shares in CPD
.


2

Macroeconomic Analysis


The macroeconomic outlook for the
global
economy is stable,
but vulnerable to
severe disruption from a number of fronts. In summary, the world essentially bought its
way out of the 2008 recession and now p
ublic debt levels in the US and Eurozone are
reaching concerning highs.

Furthermore, the lack of consensus
on h
ow to handle
Eurozone public debt issues

combined with a stubborn refusal to accept a necessary
decline in standard of living
by many Europeans has
already initiated disruptive
protests in Greece and may
generate further economic
havoc
.

The result of this
increased uncertainty is a
heightened perception of risk
and thus a spike in volatility
in the S&P 500 (^VIX)
1
.
Furthermore, d
espite record
low interest rates,
inflation
remains as much of a concern
as
deflation
in the western
world. An additional
complica
tion is that the
u
nemployment rate
in the US
has

now
increased to
9.9%,
due to discouraged workers
reentering workforce
2
, and in many other western countries it is much higher
.



Fortunately, t
he US economy appears to be
making a slow, but steady recovery.

The economy
beat expectations by adding 290,000 jobs in April,
and
the previous two
months were revised upward. In light of this,
four months of gains have
now
been
reported by the
US
private sector
1
.

Furthermore, US consumer

spending rose 3.6% last
quarter
3
.

This will give at least a short
-
term boost to industry in the US, yet the long
-
term results of negligible savings will be a drain on future growth and productivity.


Asian economies appear to be healthy and expanding
, and

this region is quickly
becoming the engine that drives the world growth
.

Inflation is definitely a concern in
these areas, but so far the Asian economies have not overheated. Other strong
economies are Australia, Brail, and oil exporting Middle Eastern co
untries.





1

Yahoo Finance. Retrieved May 13, 2010.
http://finance.yahoo.com/q/bc?s=^VIX&t=5y&l=on&z=m&q=c&c=
.

2

CNBC. Retrieved May 13, 2010. <
http://www.cnbc.com/id/37015227
>.

3

Financ
ial Times. Retrieved May 13, 2010.
http://www.ft.com/cms/s/0/39267b36
-
5450
-
11df
-
b75d
-
00144feab49a.html?nclick_check=1
.


Figure 1. Volatility Index (^VIX). Yahoo Finance


3

Industry Analysis


The pharmaceutical industry began in the 1920’s with the production and
commercialization of antibiotics and other compounds and has grown into a Trillion
dollar component of the healthcare sector. Historically pharmaceuticals
have been an
extremely profitable industry, but this is arguably justified because of the high
-
risk
nature of the business. Transitioning a drug from discovery to the marketplace can
require more than $800 million and research needs to begin on approximate
ly 5000 new
compounds for one drug to reach the shelf. Of these drugs only 1/3 will recoup
development costs
4
. This results in one of the highest barriers to entry of any modern
industry. Furthermore, profits are under constant and increasing threat from
a number
of serious challenges including patent expiration, disregard of patents by foreign
countries, generic drug competition, increased costs associated with bringing new drugs
to market, declining numbers of novel drugs in the development pipeline, and

declining
sales revenue due to increased cost
-
management by customers. Despite these obstacles,
the manufacturing of
pharmaceutical

agents

continues to be a very profitable industry.
Nevertheless, developing premium priced break
-
through therapies has been
, and will
continue to be, the key to profits and sustained competitive advantage in this industry.


In order for a new drug to enter the marketplace it must be determined to be
both safe and effective by the food and drug administration (FDA). The approv
al process
requires the completion of three rounds of human testing denoted as phase I, II, and III
clinical trials. The FDA continues to track severe adverse events, safety and effectiveness
of a drug once it is on the market. Recently, greater emphasis h
as been placed on post
-
market surveillance following the 2004 Vioxx scandal and this is a source of constant
litigation risk to firms that operate in the pharmaceutical industry.


Recent world trade organization changes have increased the patent on new dru
gs
from 17 to 20 years. This represents a substantial increase in
high
-
profit years of a
drug

s life, considering it takes approximately 10 years of patent time for a drug to reach
the market place and several more for it to be accepted for routine use by
physicians.


Pricing of drugs varies considerably among countries and between managed care
and private customers. This has proved to be a source of international tension, loss of
revenue due to black
-
market sales and litigation liability for the industry.


The manufacture of generic drugs is a lucrative and growing segment of the
pharmaceutical industry. This was facilitated by the Hatch
-
Waxman act of 1984, which
simplified the new drug application for generics and allowed 180 days of marketing
exclusivity
for the first generic drug filed.

Like most companies, an understanding of the products, markets and financial
health of the company is essential to a meaningful analysis. Of these factors the drug
portfolio of a particular company is the most essential.
Ultimately, even a company that
is too small to fund phase III clinical trials can partner with a larger, better
-
funded firm
to bring a blockbuster drug to market. The second most important feature of a new drug



4

Standard and Poor’s NetAdvantage.

Retrieved April 4, 2010.
http://www.netadvantage.standardandpoors.com.proxy.lib.pdx.edu/NASApp/NetAdvan
tage/index.do
.


4

is whether it is a prescription or non
-
presc
ription drug. Prescription drugs tend to be
focused on a specific market segment and require less marketing than non
-
prescription
drugs. Also, companies that depend on a small number of products for their revenues are
more sensitive to patent expiration.
Important questions to ask when analyzing
pharmaceutical companies are the following: when do the patents on the company’s
most important drugs expire, have recent R&D efforts been productive, has the company
formed any promising alliances, what is the com
pany’s international business profile,
how effective is the company at working with the FDA, and how effective is the company
at working with third
-
party governments and private payers? Important questions to
ask from the financial statements are the follo
wing: what are the company’s sales trends,
how wide are operating margins, what are the company’s pretax and net returns, and
what is the ROE?

The pharmaceutical industry is cash intensive
;

consequently companies typically
have twice as much cash per sal
es as other US industrial firms. This large amount of cash
is necessary to fund acquisitions and drug trials, both expensive and common in the
pharmaceutical industry. Consequently, measures of liquidity (e.g. current ratio) are
important when analyzing a
company. Leverage varies considerably among the firms in
the industry although the average is ~20%, which is half the average of US industrial
companies.

Important challenges in the industry are increased competition from generic drug
manufacturers, prici
ng pressure from customers, inflating R&D budgets, and declining
R&D productivity. The industry is responding by cutting costs, revising sales and
marketing strategies, reorganizing R&D operations, partnering with smaller
biotechnology companies, and conso
lidating.


Three demographic trends are facilitating growth in the pharmaceutical industry:
aging populations, longer life expectancy, and a rise in the incidence of chronic diseases.
In the next 40 years the over 60 population is predicted to double from
10% to more
than 20% of the world’s population. By 2030 people 65 and older will account for 19%
of the population in the United States, up from 13% in 2008
5
. Aging populations should
provide a constant source of growth for the pharmaceutical industry sinc
e older people
consume more drugs.


One important topic that is currently being discussed is the approval process for
generic version of biologics. These are therapeutic agents that are produced from living
source material (e.g. cell lines) and are frequen
tly very difficult to replicate. For example,
many recent therapeutic agents utilize antibodies. These are harvested from a unique
cell line that is impossible for another company to identically replicate. Consequently,
the “generic” product produced by a

competitor may not be a bioequivalent to the
original drug. Despite potential differences in bioactivity and murky regulatory
guidelines, many large pharmaceutical companies are venturing into the production of
generic biologics due to the enormous financ
ial rewards that are possible. Although
recent work by the FDA has demanded greater safety and efficacy testing of generic



5

Standard and Poor’s Net Adv
antage. Retrieved May 14, 2010.
http://www.netadvantage.standardandpoors.com.proxy.lib.pdx.edu/NASApp/NetAdvan
tage/showIndustr
ySurvey.do?code=hep
.


5

biologics, the large profits that await generic manufacturers and cost savings by
consumers (particularly the US government) means th
at new legislation detailing the
introduction of these products should soon be forthcoming. This will be at the expense of
firms that sell soon
-
to
-
be off
-
patent biologics.

According to Yahoo Finance
6
, the current market capitalization of the healthcare
sec
tor is 2.086 trillion. Of this, major drug manufacturers represent 992 billion, or 48%
of the healthcare sector. According to Yahoo Finance, an average firm in the major drug
manufacturing industry had a market capitalization of 32 billion, a P/E ratio of

11.7,
price/book ratio of 13.13, and net profit margins of 22.7%
7
.

Domestic drug expenditures increased from $228 billion in 2007 to $235 billion
in 2008. Government spending represented 37% of pharmaceutical purchases in 2008,
up from 17% in 1990. This m
eans that the revenues of the pharmaceutical industry are
increasingly being determined by the whims of government decision makers. Drug
spending on prescription drugs has been growing at an average annual rate of 12.4%,
although the growth has significant
ly slowed in the last two years because of patent
expiration and the global recession. Drug prices have been outpacing the CPI since at
least the 1980’s, although recently this trend has decreased due to the increasing
number of generic drug sales being in
cluded in the statistics and the industry imposed
restraint on price increases in fear of government pricing controls. Total R&D spending
for the Pharmaceutical industry increased from $47.9 billion in 2007 to $50.2 billion in
2008.

An additional concern
for domestic pharmaceutical companies is that much of
their income originates from foreign sources; approximately 2/5
th

of the total sales of US
pharmaceutical companies are from non
-
US customers. This exposes
companies to
exchange rate fluctuations and re
gulation by foreign governments.

The generic pharmaceuticals
in particular will prosper in the future due to the
following reasons: (1
) increased number of formerly patented drugs
currently

avail
able
to generic competition; (2
)
the desire for
cost containm
en
t by g
overnmental and third
-
party payer healthcare

organizations
; (
3
) increased acceptance of generic drugs by
physicians, pharmacists and consumers; (
4
) modification of state and federal laws to
encourage

substitution of generic drugs by pharmacists; an
d (
5
)
newly streamlined

ANDA procedures for obtaining FDA approval
for generic drugs
.

The pharmaceutical industry has a bright future due to its expansion into large
foreign markets and the aging of the world’s population and should certainly be
represented in a diversified portfolio. Nevertheless it faces considerable challenges
including
generic competition, government pricing restrictions, short patent times, and a
decline in R&D productivity. Future directions for the industry include a focus on
difficult to copy biologics and personalized medicines, generic drug production, and
expandin
g the clinical use, and patent life, of existing medicines. The industry is very
dispersed and smaller companies, especially small generic drug manufactures and
producers of biologics, have recently been the targets of acquisitions.




6

Yahoo Finance. April 3, 2010.
http://biz.yahoo.com/ic/510.html
.

7

Yahoo Finance. Retrieved May 13, 2010.
http://biz.yahoo.com/p/5
10conameu.html
.


6

Company Background


Caraco Pharmaceutical Laboratories, LTD.

(CPD)
, is engaged in the
manufacturing, marketing and distribution of generic pharmaceuticals. The company
was founded in 1984 and is located in Detroit, MI. Caraco is majority owned
(76%)
by
Sun Pharmaceutical Indu
stries, LTD, which is currently the 5
th

largest pharmaceutical
manufacturer in India

(Market cap in US dollars =
$68.16 Billion
)
8
.
CPD

serves as the US
-
based producer and distributor for Sun
,

and distributing Sun products accounted for
67% of CPD’s revenue

in 2009
.
Sun supplies CPD with raw materials, formulations,
machi
nery, and technical expertise and f
our of CPG’s board members were, or are,
affiliated with Sun.


Currently more than 60
CPD
products are awaiting approval by the FDA
,
suggesting that a gro
wing revenue stream will be
generated

in the future
.
CPD has
identified three areas of growth and development for the company: marketing Sun
technology, internal research and development,
and
outsourced development. Currently
CPD
produce
s

52 prescription d
rugs in 113 strengths
9
.

Expenditures for in
-
house
research and development were $22.5, 29.7, and 22.4 million for 2009, 2008, and 2007
respectively. Research and development for CPD generally refers to the development of
new formulations, absorption, and s
tability testing of off
-
patent drugs produced on
-
site
in order to demonstrate their bioequivalence to the initial patented compound that
completed clinical trials.


During 2009 the FDA cited CPD for violat
ion of
current good manufacturing
practices (cGMP).

This instigated a
series of voluntary r
ecalls
by CPD that
reduced pre
-
tax revenue by $4.7 million in 2009. This
, notably, had

only a minor effect
(
1.4%)
on
sales, since total sales for 2009 were $337 million.
CPD
had
received a
previous
warning
from the
FDA about

cGMP
in 2000,
but

was cleared in 2001
10
.

The primary solution to
these problems has been the a
dditio
n of new
personnel

and retooling of some
production machinery
.
To overcome these temporary complications at their Detroit
facility
,

the
m
anufacturi
ng of some products has been
transferred to

four other
manufacturing sites

o
perated by Sun Pharmaceuticals.


The strategy of the company
as outlined in their 2009 10
-
K
is to “
analyze the
marketplace and try to determine opportunities for products having go
od market potential, that
are difficult to develop, that require difficult
-
to
-
source raw materials and/or products
representing smaller therapeutic niche markets. We are marketing and developing products
which will face potential patent litigation, and/or
first to file opportunities. We anticipate also
seeking opportunities to in
-
license authorized generics and other generic pharmaceuticals. We
will also look to market other third party products that do not conflict with our current
pipeline of products tha
t we develop internally, or that we market or will market on behalf of



8

Based stock price of 1545 Indian rupee, exchange rate of 0.213, and 207,116,391
shares. Sun Pharmaceuticals, 2009 Annual Report. <
http://www.sunpharma.com
>.

9

Caraco. Retrieved May 15, 2010.
http://www.caraco.com/
.

10

Caraco 10
-
K 2009.

Retrieved May 15, 2010.
<
http://www.sec.gov/Archives/edgar/data/887708/000116923209003031/d77204_1
0
-
k.htm
>.


7

Sun Pharma.
11
…We believe the primary factors driving competition in the generic
pharmaceutical industry are price, product development, timely FDA approval, manufacturing
capabilities, p
roduct quality, cu
stomer service and reputation.”


Pharmaceuticals in general, are relatively
demand
-
inelastic products that are insulated
from the fluctuations of the business cycle. During recessions, however, some shift towards a
preference for generic
drugs will occur. This is likely a shift that will not reverse
once a

recession fades, since once consumers discover that a cheaper generic version of their drug
works equally as well they will
continue to use

it.


Business Model: Products & Markets


Caraco

operates in two segments, manufactured products and distributed
products
. The second group is primarily

from Sun Pharmaceuticals. The relative
contribution to yearly sales of each of these components over the last three years is
detailed in Figure
2
.







Year Ended March 31, 2009




Year Ended March 31, 2008




Year Ended March 31, 2007












































Category




Sales




Gross Profit




Sales




Gross Profit




Sales




Gross Profit




























































Manufactured Products



$

111,754,209



$

48,132,508



$

125,251,055



$

61,342,641



$

112,467,447



$

56,426,473



Distributed Products





225,423,273





19,662,047





225,115,634





23,372,509





4,559,569





1,357,685











































Total



$

337,177,482



$

67,794,555



$

350,366,689



$

84,715,150



$

117,027,016



$

57,784,158














































Notab
le features of recent sales activity
in the manufactured product segment
are
that
profit margins were reduced in 2009 compared to the previous two years (
2007,
50%; 2008, 49%; 2009,
43%). This reflects
increased sales of lower margin products,
losses due t
o the recall of product, and, presumably,
price competition from other
generic manufacturers.

Notably, t
hese gross profit margins are similar to competitors,
see figure
3
.

Company Name

Ticker

2009

2008

2007

Hi Tech Pharmac
eutical

HITK

48%

34%

39%

Mylan,
Inc.

MYL

40%

40%

42%

Par Pharmaceutical C
o.

PRX

28%

30%

21%

SeraCare Life Sciences

SRLS

34%

31%

36%

Watson

Pharmaceuticals

WPI

43%

41%

42%

Figure
3
. Profit margins of competitors
12
.





11

Caraco 10
-
K 2009.

Retrieved May 15, 2010.
<
http://www.sec.gov/Archives/edgar/data/887708/000116923209003031/d77204_1
0
-
k.htm
>.

12

Compiled from Yahoo Finance. Retrieved May 23, 2010. <

http://finance.yahoo.com
>.

Fig. 2. CPD 2009 10
-
K


8


CPD pro
duces a wide range of pharmaceutical products, as indicated by Figure
4
.
Notable
changes in sales between 2008 and 2009
among their more important products
are a 42% decrease in anticonvulsants, an 11% increase in anti
-
ulcerants,
a
27%
decrease in opiate
analgesics, and a 342% increase in oncology adjunct.

Therapeutic Category



Net Sales

Year Ended

March 31,

2009



Net Sales

Year Ended

March 31,

2008



Net sales

Year Ended

March 31,

2007



















Analgesic



$

344,920



$





$





Anorectic





1,757,126





266,230









Antiallergic Drugs





2,076,743





2,194,004









Antianxiety Drug





3,733,838





4,563,207





4,035,902



Antibiotic





424,934





417,941





506,592



Anticonvulsant





43,013,058





73,850,445





4,293,332



Antidepressant





13,781,861





16,294,454





14,053,823



Antidiabetic





20,162,183





23,394,110





30,056,770



Antiematic





10,978















Anti
-
gout





803,505





132,687









Antihypertensive Drug/Beta Blocker





20,271,051





22,700,396





19,751,939



Antipsychotic





7,465,342





5,936,243





3,530,898



Antithryoid Agents





735,277





1,568









Antitussive





89,451















Anti Ulcerants





149,583,614





134,735,991









Bisphosphonate Derivative





148,843















Calcium Channel Blocker





9,174,500





7,709,527









Cardiac





6,844,618





2,893,926





2,446,608



Decongestants

















62,814



Narcotic Analgesics





156,586





165,860









Nonsteroidal Antiinflammatory Agent





4,437,107





3,154,862





2,886,593



Opiate Agonist/Analgesic





28,652,439





38,567,526





31,257,560



Oncology Adjunct





16,839,293





3,816,026









Parkinson’s Disease





1,110,877





4,227









Platelet Aggregation Inhibitor





164,013





211,345





206,185



Sedatives & Hypnotics





883,799





1,642,383









Skeletal Muscle Relaxant





3,232,998





3,935,676





2,902,770



Vascular and Migraine Headache Suppressant





1,278,528





3,778,055





1,035,230















































Net Sales





$


337,177,482





$


350,366,689





$


117,027,016



























Fig. 4. Product composition of net sales, CPD 2009 10
-
K.


9


In the
distributed products segment
,

margins saw a dramatic dec
rease over the
last three years

(2007, 30%; 2008, 20%; 2009, 9%). This is an unsustainable rate of
decline.
Comparison with three large drug wholesale distributors reveals that profit
margins will lik
ely stabilize in the 3
-
6% range for the long term, Figure
5
.


Company Name

Ticker

2009

2008

2007

Cardinal Health, Inc.

CAH

5.5
%

6.1
%

6.0
%

McKesson Corporation

MCK

5.2
%

5.0
%

4.9
%

AmerisourceBergen
Corporation

ABC

2.9
%

2.8
%

3.5
%

Figure
5
. A comparison of

profit margins among large wholesale drug distributors.
13


Business Model
:

Production and Distribution

The entirety of CPD’s manufactured product line is produced at
its

facility in
Detroit, MI. Although they claim to have access to other facilities, presu
mably through
Sun Pharmaceuticals, the possibility does exist that their primary production facility
could be closed down for a
long
period of time and disrupt production. The likelihood of
this occurring is remote
, but clearly possible, since it occurred
in 2009
.

The primary
response to this has been to deplete inventories, but some product has likely shifted to
alternative production facilities.


The
materials used in the manufacture of pharmaceuticals are active and inactive
chemical ingredients and packaging materials. The
majority of
the
active pharmaceutical
ingredients (APIs), were purchased from Sun Pharmaceuticals (69%, 66% and 79% in
2009, 2008

and 2007)
, although the company maintains that other suppliers are
available
. This
concentration of suppliers
has the potential to create a bottleneck for
APIs and slow production
.

CPD recognizes this and provides the following statement in
their 2009 10
-
K. “Although to date no significant difficulty has been encountered in
obtaining components required for products and sources of supply are considered
adequate, there can be no assurance that we will continue to be able to obtain
components as required.
14



Distribution of product primarily occurs through the interaction of sales staff
with CP
D
’s principle customers: wholesale drug distributors, major retail drug store
chains, and managed care companies.
Indeed,

three wholesalers, Amerisource
-
Bergen
Corporat
ion, McKesson Corporation and Cardinal Health,
accounted for 45% of sales
revenues in 2009.
This suggests that several large purchasers may be in a position to
negotiate prices with CPD and adversely impact sales. It is unclear whether this will generate
s
evere pressures on profit margins in the near future.






13

Compiled from Yahoo Finance. Retrieved May 23, 2010. <

http://finance.yahoo.com
>.

14

Car
aco. 2009 10
-
K. Retrieved May 15, 2010.
http://www.sec.gov/Archives/edgar/data/887708/000116923209003031/d77204_10
-
k.htm
.


10

Business Model
:

Life Cycle Analysis

The g
eneric pharmaceutical industry is a growth industry and CPD is

a relatively
small

company with greater than average growth potential.
In the two years prior t
o the
drug r
ecall CPD grew at 41% and 199%, and the rate of growth will likely return to these
accelerated levels by 2012.
Future growth prospects for CPD and other generic
pharmaceutical manufacturers are originating from the following sources: (1
) increa
sed
number of formerly patented drugs
currently

avail
able to generic competition; (2
)
the
desire for
cost containmen
t by g
overnmental and third
-
party payer healthcare

organizations
; (
3
) increased acceptance of generic drugs by physicians, pharmacists and
c
onsumers; (
4
) modification of state and federal laws to
encourage

substitution of
generic drugs by pharmacists; and (
5
)
newly streamlined

abbreviated new drug
application (ANDA) p
rocedures for obtaining FDA approval
for generic drugs
.

Due to the fact that
drugs continue to be improved and the long
-
term promises of
the biomedical industry are so vast

(including the prevention of all major diseases and
extended human life
-
spans)

that
pharmaceuticals will continue to be
a
profitable and
growing
industry
for th
e foreseeable future.

Nevertheless
,

pricing pressures from large
purchasers, especially governments, will squeeze profit margins.


11


Business Model: Competitive Analysis


G
eneric drug manufacturing is an extremely competitive business that is
undergoing rap
id changes and frequent consolidations. Production methods are
constantly being refined and modernized and companies that fall behind in the
technology of drug manufacturing will not be in business long. Competition quickly leads
to the erosion of prices a
nd, consequently, profit margins. Many competitors of

CPD are
much larger, and have

larger budgets for production
,
research and development

of
products
. The way that CPD must
compete

is
to

maintain a competitive price, constantly
pursue innovation and deve
lopment in its manufacturing technique, seek out timely FDA
approval, strive to keep manufacturing capabilities of the highest technological level, produce
quality products, have an agg
r
essive marketing staff, and efficient customer service.
Companies that

manufacture drugs try to be the first company to introduce a generic product
after the related patent expires, because the Hatch
-
Waxman Act of 1984 provides a
180
-
day
period

of exclusive marketing. Additi
onal areas of differentiation and possible competit
ive
advantage include methods of distribution, timely delivery of product, and breadth of product
line.


Despite its small size
,

CPD
has been, and remains

competitive in the

generic drug
business.

This is largely a result of its rapid development and filing of new product
applications.
In 2009 it submitted
10 new ANDAs resulting in a total of 71 filed ANDAs. Of
these, 42 have been approved by the FDA and approvals for 29 more are expected to be
appr
oved
15
. In comparison, Impax Laboratories (IPXL), a similar generic manufacturing
company approximately 5 times the size of CPD, had 10 new ANDAs filed in 2009, 37
products total, and 32 ANDAs pending at the FDA
16
. Furthermore, CPD has distinguished
itself f
or rapid and convenient service in the Midwestern United States.



Ratio analysis
is frequently

used to compare
companies
that are similar

and
facilitate
the identification of

positive
and

negative trends
.
A comparison between CPD and several
competitors i
n the generic pharmaceut
i
cal industry was made, and is presented in figure 6.
Not surprisingly, CPD does not compare well to other companies on the list, due to the fact
that it was
selected through a screen for
moderately distressed compan
ies (this screen

primarily looked for
a low price to book
-
value ratio)
. Since its earnings were negative this
year, P/E ratios are not a useful comparison with competitors other than to verify that it is
subpar in the generic pharmaceutical sector. The slightly negative r
eturn on equity (
-
5.1%)
reflects a poor year, but not calamitous failure of their business model, like Helicos
BioSciences (HLCS) which had a ROE of
-
213%.

The price to book
-
value
ratio
also indicates
that

CPD might be a profitable investment opportunity
,
since
it has the lowest price to book
ratio (1.61) of any company
examined

in the generic pharmaceutical industry
.
This suggests
that the company has value that is not being appreciated by the current market conditions.
A
slightly negative net profit margi
n for the most recent quarter (mrq) shows that net income



15

Caraco. 2009 10
-
K. Retrieved May 15
, 2010.
http://www.sec.gov/Archives/edgar/data/887708/000116923209003031/d77204_10
-
k.htm
.


16

Impax Laboritories. . 2009 10
-
K. Retrieved May 15, 2010.
http://phx.corporate
-
ir.net/phoenix.zhtml?c=67240&p=irol
-
reportsAnnual
.


12

was slightly negative, but the company was still covering the majority of their costs through
operations, unlike HLCS
, which had a net profit margin of
-
11,142%
.

Description


Ticker

Market Cap

P/E

ROE %

Price
to
Book

Net Profit
Margin
(mrq)

Healthcare

IYH

1927.36B

23.051

17.113

10.135

16.031

Drugs
-

Generic

^YHOH785

13.21B

32

8.4

-
6.83

6

Caraco Pharmaceutical
s

CPD

236.50M

NA

-
5.056

1.61

-
5.834

Impax Laboratories

IPXL

1.34 B

7.40

68.43

3.45

28.79

Catalyst Pharmaceutical
Partners

CPRX

23.82M

NA

-
79.678

3.128

NA

Helicos BioSciences
Corporation

HLCS

46.88M

NA

-
213.525

8.082

-
11142

Hi Tech Pharmac
eutical

HITK

294.33M

9.659

28.767

2.326

21.999

Mylan, Inc.

MYL

6.34B

129.057

7.688

1.982

7.417

Par
Pharmaceutical C
o.

PRX

934.05M

10.55

18.324

1.763

9.008

SeraCare Life Sciences

SRLS

100.83M

18.259

20.392

3.29

16.312

Watson

Pharmaceuticals

WPI

5.20B

20.425

9.233

1.682

8.149

17





17

Yahoo Finance. Retrieved May 15, 2010.
<
http://biz.yahoo.com/p/512conameu.html
>.

Figure 6
. Comparitive

Ratio Analysis of Generic Pharmaceutical Manufacturers


13


SWOT Analysis

A review of CPD’s 2009
,

10
-
K suggests strengths, weaknesses, opportunities, and
threats, both explicitly stated and implied by the nature of generic drug manufacturing.
These are su
mmarized in figure 7.

Strengths

Weaknesses

1.

Supported by a large company with
a vested interest in CPD’s long
-
瑥r洠
獵s捥獳

2.

Small amount of debt

3.

Solid portfolio of products

4.

Large number of abbreviated new
drug applications being processed
by the FDA

1.

Production quality issues

2.

Declining profit margins

3.

Depends on a limited number of
large customers for the majority of
its revenue

Opportunities

Threats

1.

Collaborations with Sun
Pharmaceuticals

2.

Changing demographics

3.

Increasing healthcare spending

4.

Emerging
markets

5.

Political landscape favors generic
drug manufacturers

1.

Tightening of margins

2.

Increasing competition

3.

Small company in an industry
dominated by large firms

4.

Increasing FDA regulatory
oversight


Figure 7
: SWOT Analysis: Duane Allen


One c
lear
strength
CPD
has is

its robust support from a large generic drug
manufacturer
, Sun Pharmaceuticals
. This provides a constant and secure stream of
revenue, since CPD is the primary distributor of Sun
’s products in the United States.

Furthermore, Sun explicitly provi
des CPD with reagents, manufacturing expertise, and
alternative manufacturing facilities, and implicitly guarantees loans and funds to
overcome manufacturing difficulties.

Furthermore, t
he
historically zero, and currently
small
,

amount of debt
held
by the
firm

is
an advantage
, since interest costs are kept to a
minimum

and financial flexibility is maintained
. The most important stre
n
gth of CPD,
however, is their solid product portfolio and deep pipeline of new drug applications. As
previously mentioned, it

is of similar size as Impax Laboratories, a company that is 5
times its size and is currently a favored stock

among investors

in the generic drug
industry.


Clear weaknesses

for
CPD
are

its product quality issues, declining profit margins
and dependence
on a few large customers for much of its sales revenue. Obviously, if
product quality is not immediately improved and the Detroit production facility is not
cleared by the FDA large customers will begin to look elsewhere for their generic drugs.
This could

have a
terminal

effect on the health of the company.
In the future, p
rofit
margins will continue to be squeezed both by the parent company and by large
purchasers of
CPD
product, such as managed health organizations and government
agencies. This will
, mo
st likely, occur gradually and
will be mitigated by new, high

14

margin products
entering the sales cycle. However, decreasing gross margins are
an
eventual
negative outcome in the generic pharmaceutical industry.


Opportunities for CPD
are future collaborat
ions with Sun Pharmaceuticals, the
aging of the world’s population, increased healthcare spending by governments and
consumers, the opening up of emerging markets, and the changing political landscape in
favor of generic pharmaceuticals.

However, with the
exception of the collaboration with
Sun, all of these events will improve conditions for competitors as well, so may have no
net effect on the competitiveness of CPD.


Threats to CPD include shrinking profit margins, and increased competition,
especially b
y larger rivals. Increased scrutiny by the FDA will also potentially expose
other production issues that may result in fines and product recalls.

The most plausible
scenario is that Sun Pharmaceuticals will stop cutting corners and invest some money in
the

equipment and personnel that will allow
efficient
production to return to CPD’s
manufacturing facility.


15

Catalysts

The continued success of CPD depends on the following five catalysts:

1. Favorable Demographic Trends.

Three
favorable demographic trends

will
continue to enhance the growth prospects for CPD. These are 1) aging populations, 2)
longer life expectancy, and 3) a rise in the incidence of chronic diseases. In the next 40
years the over 60 population is predicted to double from 10% to more than 2
0% of the
world’s population. By 2030 people 65 and older will account for 19% of the population
in the United States, up from 13% in 2008
18
. Aging populations should provide a
constant source of growth for the pharmaceutical industry since older people con
sume
more drugs.

2. Drugs are Demand
-
Inelastic Products.

A second catalyst for the
pharmaceutical industry is that they produce products that people will consume no
matter what economic conditions are prevailing. This is even more true for generic
pharmace
uticals, since
recessions will push more consumers away from branded
product towards generics.


3. Acquisitions
. The pharmaceutical

industry is relatively dispersed and
acquisitions

continue to be common and a favored engine of growth

for well
-
funded
companies
. CPD may acquire other companies and grow by expansion
, espe
cially if
financed in this Endeavour

by Sun.

4. H
ealthcare
L
egislation
.

The new healthcare legislation seems
appears to be
favorable

to pharmaceutical companies and

espe
cially to the generic pharmaceutical
industry.

5. Associat
ion with Sun Pharmaceuticals
.
Sun

provides

stability and an assured
revenue stream due to the fact that
CPD is
the primary US distributor of Sun Products.
On the other hand, this association may wor
k against CPD if Sun bleeds off all the profits,
breaks
-
up the company, or assimilates it on unfavorable terms for common
shareholders.




18

Standard and Poor’s N
et Advantage. Retrieved May 14, 2010.
http://www.netadvantage.standardandpoors.com.proxy.lib.pdx.edu/NASApp/NetAdvan
tage/showI
ndustrySurvey.do?code=hep
.


16


Summary of Qualitative Findings


Caraco Pharmaceuticals, LTD. (
CPD
)

is a moderately distre
ssed producer
and
distributor
of generic pharmaceuticals.
It is largely owned by Sun Pharmaceuticals, the
5
th

largest pharmaceutical company in India, and is the primary distributor of Sun
products in the US. In 2009 it was warned by the FDA that its production facility

was not
up to code. The result was a temporary plant closure and a small recall of product. This
greatly depressed the stock price and contributed to a net loss for the year.


Additional concerns for Caraco are its decreasing profit margins and its
depen
dence on a few large customers for a large portion of its revenue.

Furthermore,

it
is a small company in a field that is dominated by large
-
volume, low
-
cost producers.


Advantages CPD has are a wide
-
range of products, a deep pipeline of new drug
applications on file with the FDA and a large corporate partner to support it if it really
gets into trouble. Furthermore, increasing healthcare spending, an aging population,
increased incidence of disease and a political landscape that favors generic dru
gs make
for favorable growth conditions.


Nevertheless, CPD still has
several issues that pose significant future risks. First,
corners have clearly been cut in the past and this has led to
a

failed FDA inspection and
subsequent production problems. It rem
ains unclear whether CPD has learned their
lesson or not. Secondly, being a subsidiary of Sun Pharmaceuticals poses the risk of
being taken over on unfavorable terms to normal investors. It also has the risk, as
illustrated by
the
declining profit margins
from its distributed product segment
, that Sun
may suck all
of
the profit out of the company, leaving nothing for
CPD to
distribu
te to
investors

or
use for
growth.

17


Financials

Income Statement:




ANNUAL
INCOME
STATEMEN
T








(MILLIONS,
EXCEPT
PER
SHARE)













CARACO PHARMACEUTICAL
LABS



SIC: 2834 (Pharmaceutical
Preparations)



1150 Elijah McCoy Dr



GICS: 35202010
(Pharmaceuticals)



Detroit, MI 48202




S&P Long
-
Term Issuer
Credit Rating:



Ticker: CPD




S&P Short
-
Term Issuer
Credit Rating:



Fiscal Year: 3










LTM













Dec09

Mar09

Mar08

Mar07

Mar06

Dec04












Sales


229.428

337.177

350.367

117.027

82.789

60.340

Cost of Goods Sold


207.380

265.939

263.142

57.311

40.320

24.441



----------------
-

-----------------
--

--------------
----

----------------
--

----------------
--

--------------
-

Gross Profit


22.048

71.238

87.225

5
9
.
7
1
6


42.469

35.899

Selling, General, & Administrative Exp.

34.471

38.946

44.009

32.233

51.374

34.795



----------------
-

-----------------
--

--------------
----

----------------
--

----------------
--

--------------
-

Operating Income Before Deprec.

(12.423)

32.292

43.216

27.483

(8.905)

1.104

Depreciation,Depletion,&Amortization

4.453

3.443

2.509

1.931

1.553

0.932



----------------
-

-----------------
--

--------------
----

----------------
--

----------------
--

--------------
-

Operating Profit


(16.876)

28.849

40.707

25.552

(10.458)

0.172












Interest Expense


0.430

0.028

0.000

0.028

0.004

0.407

Non
-
Operating Income/Expense

0.646

0.631

1.832

1.339

0.339

0.047

Special Items


3.936

0.000

(0.145)

(0.005)

(0.300)

(0.011)



----------------
-

-----------------
--

--------------
----

----------------
--

----------------
--

--------------
-

Pretax Income


(12.724)

29.452

42.394

26.858

(10.423)

(0.199)

Total Income Taxes


(4.524)

8.915

7.006

0.000

0.000

0.000

Minority Interest


0.000

0.000

0.000

0.000

0.000

0.000



----------------
-

-----------------
--

--------------
----

----------------
--

----------------
--

--------------
-

Income Before Extraordinary










Items & Discontinued Operations

(8.200)

20.537

35.388

26.858

(10.423)

(0.199)

Preferred Dividends


0.000

0.000

0.000

0.000

0.000

0.000



----------------
-

-----------------
--

--------------
----

----------------
--

----------------
--

--------------
-

Available for Common

(8.200)

20.537

35.388

26.858

(10.423)

(0.199)

Savings Due to Common Stock Equiv.

0.000

0.000

0.000

0.000

0.000

0.000



----------------
-

-----------------
--

--------------
----

----------------
--

----------------
--

--------------
-

Adjusted Available for Common

(8.200)

20.537

35.388

26.858

(10.423)

(0.199)

Extraordinary Items


0.000

0.000

0.000

0.000

0.000

0.000

Discontinued Operations

0.000

0.000

0.000

0.000

0.000

0.000



----------------
-

-----------------
--

--------------
----

----------------
--

----------------
--

--------------
-

Adjusted Net Income


(8.200)

20.537

35.388

26.858

(10.423)

(0.199)












Earnings Per Share Basic
-










Excluding Extra Items & Disc Op

(0.230)

0.600

1.190

1.020

(0.390)

(0.010)












Earnings Per Share Basic
-










Including Extra Items & Disc Op

(0.230)

0.600

1.190

1.020

(0.390)

(0.010)












Earnings Per Share Diluted
-










Excluding Extra Items & Disc Op

(0.220)

0.510

0.890

0.720

(0.390)

(0.010)












Earnings Per Share Diluted
-










Including Extra Items & Disc Op

(0.240)

0.510

0.890

0.720

(0.390)

(0.010)












EPS Basic from Operations

(0.290)

0.600

1.200

1.020

(0.380)

(0.010)

EPS Diluted from Operations

(0.290)

0.510

0.900

0.720

(0.380)

(0.010)

Dividends Per Share


0.000

0.000

0.000

0.000

0.000

0.000











Com Shares for Basic EPS

39.090

34.227

29.657

26.447

26.392

24.734

Com Shares for Diluted EPS

39.090

40.576

39.914

37.255

26.392

24.734

Copyright: Standard & Poor's, A Division of McGraw
-
Hill Companies, Inc.







18

Balance
Sheet:

ANNUAL BALANCE SHEET

($ MILLIONS)









CARACO PHARMACEUTICAL LABS




SIC: 2834 (Pharmaceutical Preparations)


1150 Elijah McCoy Dr




GICS: 35202010 (Pharmaceuticals)


Detroit, MI 48202




S&P Long
-
Term Issuer Credit Rating:


Ticker:
CPD




S&P Short
-
Term Issuer Credit Rating:


Fiscal Year: 3










Latest Q













Dec09

Mar09

Mar08

Mar07

Mar06

Dec04

ASSETS










Cash & Short
-
Term Investments


76.691

65.314

56.906

33.898

11.924

2.456

Net Receivables


82.212

15.181

135.927

26.125

20.859

4.603

Inventories


66.122

79.511

298.666

31.943

26.966

17.134

Prepaid Expenses


NA

@CF

@CF

@CF

@CF

@CF

Other Current Assets


13.262

9.858

8.523

3.473

2.533

0.664



------------------

--------------
----

--------------
----

--------------
----

--------------
----

------------
--

Total Current Assets


238.287

169.864

500.022

95.439

62.282

24.857











Gross Plant, Property & Equipment


61.673

59.558

32.705

29.708

23.710

19.437

Accumulated
Depreciation


17.913

14.735

11.438

10.678

8.750

6.891



------------------

--------------
----

--------------
----

--------------
----

--------------
----

------------
--

Net Plant, Property & Equipment


43.760

44.823

21.267

19.030

14.960

12.546


Investments at Equity


NA

0.000

0.000

0.000

0.000

0.000


Other Investments


NA

0.000

0.000

0.000

0.000

0.000


Intangibles


NA

1.383

0.000

0.000

0.000

0.000


Deferred Charges


NA

0.000

0.000

0.000

0.000

0.000

Other Assets


22.625

20.418

16.986

0.000

0.000

0.000



------------------

--------------
----

--------------
----

--------------
----

--------------
----

------------
--

TOTAL ASSETS


304.672

236.488

538.275

114.469

77.242

37.403











LIABILITIES










Long Term Debt Due In One Year


16.200

2.700

0.000

0.000

0.000

0.000

Notes Payable


NA

0.000

0.000

0.000

0.000

0.000

Accounts Payable


123.674

51.908

393.068

15.493

18.375

9.916

Taxes Payable


5.063

0.000

0.142

0.000

0.000

0.000

Accrued Expenses


NA

2.757

2.285

3.783

2.489

1.711

Other Current Liabilities


1.519

0.000

0.000

0.000

0.000

0.000



------------------

--------------
----

--------------
----

--------------
----

--------------
----

------------
--

Total
Current Liabilities


146.456

57.365

395.495

19.276

20.864

11.627











Long Term Debt


0.000

15.300

0.000

0.000

0.000

0.000

Deferred Taxes


0.000

0.000

0.000

0.000

0.000

0.000

Investment Tax Credit


@CF

0.000

0.000

0.000

0.000

0.000

Minority Interest


0.000

0.000

0.000

0.000

0.000

0.000

Other Liabilities


0.000

0.000

0.000

0.000

0.000

0.000



------------------

--------------
----

--------------
----

--------------
----

--------------
----

------------
--

TOTAL
LIABILITIES


146.456

72.665

395.495

19.276

20.864

11.627











EQUITY










Preferred Stock
-

Redeemable


@CF

0.000

0.000

0.000

0.000

0.000

Preferred Stock
-

Nonredeemable


11.321

23.082

58.137

73.586

72.756

27.500



------------------

--------------
----

--------------
----

--------------
----

--------------
----

------------
--

Total Preferred Stock


11.321

23.082

58.137

73.586

72.756

27.500











Common Stock


130.331

118.569

83.332

55.970

44.989

44.897

Capital Surplus


3.654

3.474

3.149

2.864

2.718

2.719

Retained Earnings


12.910

18.698

(1.838)

(37.227)

(64.085)

(49.340)

Less: Treasury Stock


0.000

0.000

0.000

0.000

0.000

0.000



------------------

--------------
----

--------------
----

--------------
----

--------------
----

------------
--

Common Equity


146.895

140.741

84.643

21.607

(16.378)

(1.724)



------------------

--------------
----

--------------
----

--------------
----

--------------
----

------------
--

TOTAL EQUITY


158.216

163.823

142.780

95.193

56.378

25.776



------------------

--------------
----

--------------
----

--------------
----

--------------
----

------------
--

TOTAL LIABILITIES & EQUITY


304.672

236.488

538.275

114.469

77.242

37.403











Common Shares Outstanding


39.090

37.458

32.551

28.102

26.422

26.335









Copyright: Standard & Poor's, A Division of McGraw
-
Hill Companies, Inc.






19

Statement of Cash Flows:




ANNUAL
STATEMEN
T OF CASH
FLOWS








($
MILLIONS)












CARACO PHARMACEUTICAL LABS




SIC: 2834 (Pharmaceutical Preparations)


1150 Elijah McCoy Dr




GICS: 35202010 (Pharmaceuticals)


Detroit, MI 48202




S&P Long
-
Term Issuer Credit Rating:


Ticker: CPD




S&P Short
-
Term Issuer
Credit Rating:


Fiscal Year: 3










LTM













Dec09

Mar09

Mar08

Mar07

Mar06

Dec04

INDIRECT OPERATING ACTIVITIES










Income Before Extraordinary Items


(8.200)

20.537

35.388

26.858

(10.423)

(0.199)

Depreciation and Amortization


4.453

3.370

2.509

1.931

1.553

0.932

Extraordinary Items and Disc. Operations


0.000

0.000

0.000

0.000

0.000

0.000

Deferred Taxes


(7.305)

(3.487)

(17.348)

0.000

0.000

0.000

Equity in Net Loss (Earnings)


0.000

0.000

0.000

0.000

0.000

0.000

Sale of Property, Plant, and Equipment










and Sale of Investments
-

Loss (Gain)


0.114

0.000

0.145

0.005

0.000

0.011

Funds from Operations
-

Other


0.267

0.495

12.080

11.908

35.054

24.396

Receivables
-

Decrease (Increase)


(69.166)

120.746

(109.802)

(5.266)

(14.122)

(0.064)

Inventory
-

Decrease (Increase)


59.133

219.154

(266.722)

(4.978)

(8.498)

(7.523)

Accounts Payable and Accrued Liabs
-
Inc (Dec)


49.701

(340.688)

376.076

(1.588)

6.715

4.626

Income Taxes
-

Accrued
-

Inc (Dec)


5.063

(0.142)

0.142

0.000

0.000

0.000

Other Assets and Liabilities
-

Net Change


(0.017)

(1.280)

(4.688)

(0.941)

(1.427)

(0.140)

Operating Activities
-

Net Cash Flow


34.043

18.705

27.780

27.929

8.852

22.039











INVESTING ACTIVITIES










Investments
-

Increase


0.000

0.000

0.000

0.000

0.000

0.000

Sale of Investments


0.000

0.000

0.000

0.000

0.000

0.000

Short
-
Term Investments
-

Change


(10.000)

0.000

0.000

0.000

0.000

0.000

Capital
Expenditures


7.526

26.852

5.094

6.006

3.616

3.982

Sale of Property, Plant, and Equipment


0.000

0.000

0.203

0.000

0.000

0.000

Acquisitions


0.000

0.000

0.000

0.000

0.000

0.000

Investing Activities
-

Other


0.000

(1.456)

0.000

0.000

0.000

0.000

Investing Activities
-

Net Cash Flow


(17.526)

(28.308)

(4.891)

(6.006)

(3.616)

(3.982)











FINANCING ACTIVITIES










Sale of Common and Preferred Stock


0.000

0.011

0.120

0.050

0.061

3.454

Purchase of Common and
Preferred Stock


0.000

0.000

0.000

0.000

0.000

0.000

Cash Dividends


0.000

0.000

0.000

0.000

0.000

0.000

Long
-
Term Debt
-

Issuance


18.000

18.000

0.000

0.000

0.000

0.000

Long
-
Term Debt
-

Reduction


0.000

0.000

0.000

0.000

0.000

0.000

Current Debt
-

Changes


@CF

@CF

0.000

0.000

0.000

(23.261)

Financing Activities
-

Other


0.000

0.000

0.000

0.000

0.000

0.000

Financing Activities
-

Net Cash Flow


16.200

18.011

0.120

0.050

0.061

(19.807)

Exchange Rate Effect


0.000

0.000

0.000

0.000

0.000

0.000

Cash and Equivalents
-

Change


32.717

8.408

23.009

21.973

5.297

(1.750)











DIRECT OPERATING ACTIVITIES










Interest Paid
-

Net


@NA

0.000

0.000

0.028

0.004

0.407

Income Taxes Paid


@NA

15.600

24.210

@NA

@NA

@NA











SUPPLEMENTAL STATEMENT
-
FINANCIAL
POSITION









Total Funds from Operations


NA

@NA

@NA

@NA

@NA

@NA

Other Sources of Funds


NA

@NA

@NA

@NA

@NA

@NA

Total Sources of Funds


NA

@NA

@NA

@NA

@NA

@NA

Total Working
Capital Change


NA

@NA

@NA

@NA

@NA

@NA

Other Uses of Funds


NA

@NA

@NA

@NA

@NA

@NA

Total Uses of Funds


NA

@NA

@NA

@NA

@NA

@NA

Working Capital Changes
-

Other
-

Inc (Dec)


NA

@NA

@NA

@NA

@NA

@NA









Copyright: Standard & Poor's, A Division of
McGraw
-
Hill Companies, Inc.






20


Discounted Cash Flow Valuation


The
following
assumptions
were made to generate the discounted cash flow
model of CPD:

1.

Revenue
growth is
dramatically impaired in 2010 (
-
30%), recovers in 2011 to the
average of the
trailing four years (80%), then declines to a high
-
growth, three
-
year recovery period (25%) which trails off to a long
-
term value that equals the
rate of inflation (2.82%) by 2018.

2.

Gross capital expenditures in 2010 were twice the average value of the trai
ling
four years. After 2010 the value was allowed to self
-
adjust with the model.

3.

After
-
tax EBITA as a percent of revenue, depreciation and amortization as a
percent of net P&E, net working capital less cash as a percentage of revenues, net
P&E as a percent
age of revenues, debt to total liabilities and net worth, interest
rate, and effective tax rate for interest are all held at the average value of the
trailing four years. This is either because these values did not change very much,
or had minimal impact o
n the valuation if they were changed between reasonable
levels.


21


CARACO PHARMACEUTICAL LABS (CPD)










Calculation of FCFF and FCFE






This layout is designed to facilitate projections, and follows the definitions in Damodoran 2ed., p. 382
-
3.






Free cash flows to the firm (FCFF) *

2009

2008

2007

2006

Effective tax rate computation






Taxes from income statement


8.92


7.01


-



-



Change in deferred income taxes from B.S.


-



-



-



-



Cash taxes paid


8.92


7.01


-



-



Pre
-
tax income


29.45


42.39


26.86


(10.42)


Effective cash tax rate

30.3%

16.5%

0.0%

0.0%






EBIT**


28.85


40.71


25.55


(10.46)

EBIT(1
-
t)


20.12


33.98


25.55


(10.46)

Add depreciation and amoritization


3.44


2.51


1.93


1.55

After
-
tax EBITDA


23.56


36.49


27.48


(8.91)











Change in net working capital






Current assets less cash


104.55


443.12


61.54


50.36


Prior year C.A. less cash


443.12


61.54


50.36


22.40


Change in current assets less cash


(338.57)


381.58


11.18


27.96







Current liabilities


57.37


395.50


19.28


20.86


Prior year C.L.


395.50


19.28


20.86


11.63


Change in current liabilities


(338.13)


376.22


(1.59)


9.24


Change in non
-
cash W.C.


(0.44)


5.36


12.77


18.72






Gross capital expenditures






Net P&E


44.82


21.27


19.03


14.96


Prior year Net P&E


21.27


19.03


14.96


12.55


Add depreciation


3.44


2.51


1.93


1.55


Gross capital expenditures


27.00


4.75


6.00


3.97






FCFF


(3.00)


26.39


8.71


(31.59)






Free cash flows to equity (FCFE)***





FCFF


(3.00)


26.39


8.71


(31.59)

Add net increase in debt, minority interest, and
other non
-
current

liabilities from B.S.


15.30


-



-



-


Effective tax rate for interest****

30.3%

16.5%

0.0%

0.0%

Subtract after
-
tax interest expense


0.02


-



0.03


0.00

FCFE


12.28


26.39


8.68


(31.60)






*(p 383 of Damodoran, 2ed): FCFF =
EBIT(1
-
t) + depreciation
-

capital expenditures
-

change in working capital

** Includes EBIT + Other income. How Other income is treated depends on what it is.


***(p 382 of Damodoran, 2ed):





FCFE = FCFF
-

Interest Exp (1
-
t)
-

Principal repayments + new debt issues
-

preferred dividends


(note I have rearranged the equation to solve for FCFE




**** Here defined as income taxes/pre
-
tax
income





Differs from above effective interest
because marginal tax rate for interest is not likely deferrable




22


CARACO PHARMACEUTICAL LABS (CPD)






May 5, 2010






Note: Blue numbers indicate numerical input by user





Note: Green = average of 2006
-
2009 values






Forecast of Free Cash Flows for Caraco Laboratories




First 4 columns are reversed from the FCFF
-
FCFE spreadsheet






Forecast





Parameters used in forecast

Parameters

2006

2007

2008

2009











Growth rate of revenues

79.0%


41.36%

199.39%

-
3.76%

After
-
tax EBITDA as a percent of revenue

7.5%

-
11%

23.5%

10.4%

7.0%

Deprec and amort as % net P&E

13.7%

12.4%

12.9%

13.2%

16.2%

Net working capital less cash as % revenues

8.7%

22.6%

10.9%

1.5%

-
0.1%

Net P&E as % revenue

13.4%

18.1%

16.3%

6.1%

13.3%







For FCFE calculations






Debt to Total Liabilities and Net Worth

1.6%

0.0%

0.0%

0.0%

6.5%

Interest rate

2.0%







0.2%

Effective tax rate for interest*

11.7%

0.0%

0.0%

16.5%

30.3%

* Here defined as income taxes/pre
-
tax income












Free cash flows to the firm (FCFF) *


2006

2007

2008

2009







Revenue Forecasts


82.79

117.03

350.37

337.18

After
-
tax EBITDA



(8.91)


27.48


36.49


23.56







Change in net working capital







Net working capital less cash

9


18.72


12.77


5.36


(0.44)


Prior year net working capital less cash



10.77


18.72


12.77


5.36


Change in net working capital less cash



7.95


(5.95)


(7.42)


(5.79)







Gross capital expenditures







Net P&E



14.96


19.03


21.27


44.82


Prior year Net P&E



12.55


14.96


19.03


21.27


Change in Net P&E



2.41


4.07


2.24


23.56


Add depreciation



1.55


1.93


2.51


3.44


Gross capital expenditures

10


3.97


6.00


4.75


27.00







FCFF



(31.59)


8.71


26.39


(3.00)







Free cash flows to equity (FCFE)**


2006

2007

2008

2009

FCFF



(31.59)


8.71


26.39


(3.00)

Debt and other non
-
current liabilities



-



-



-



15.30

Prior year debt and other non
-
current liab.



-



-



-



-



Net increase (add)



-



-



-



15.30

Interest before tax



0.00


0.03


-



0.03

Subtract after
-
tax interest expense



0.00


0.03


-



0.02

FCFE



(31.60)


8.68


26.39


12.28







*(p 383 of Damodoran

2ed): FCFF = EBIT(1
-
t) + depreciation
-

capital expenditures
-

change in working capital


**(p 382 of Damodoran 2ed):






FCFE = FCFF
-

Interest Exp (1
-
t)
-

Principal repayments + new debt issues
-

preferred dividends



(note

I have rearranged the equation to solve for FCFE
























23


Short run


Intermediate high growth period







2010

2011

2012

2013

2014


Revenues depressed for two years assuming acquisitions





-
30.00%

80.00%

25.00%

25.00%

25.00%

7.5%

7.5%

7.5%

7.5%

7.5%

13.7%

13.7%

13.7%

13.7%

13.7%

8.7%

8.7%

8.7%

8.7%

8.7%

13.4%

13.4%

13.4%

13.4%

13.4%















1.6%

1.6%

1.6%

1.6%

1.6%

2.0%

2.0%

2.0%

2.0%

2.0%

11.7%

11.7%

11.7%

11.7%

11.7%















2010

2011

2012

2013

2014









236.02


1,092.45


1,365.57


1,706.96


2,133.70


17.78


82.29


102.86


128.58


160.72
















20.61


95.38


119.23


149.03


186.29


(0.44)


20.61


95.38


119.23


149.03


21.04


74.77


23.85


29.81


37.26
















58.70


146.65


183.31


229.14


286.42


44.82


58.70


146.65


183.31


229.14


13.87


87.95


36.66


45.83


57.28


6.13


8.02


20.04


25.05


31.31


20.00


95.97


56.70


70.88


88.60









(23.26)


(88.46)


22.31


27.89


34.87








2010

2011

2012

2013

2014


(23.26)


(88.46)


22.31


27.89


34.87


0.56


3.20


4.18


5.40


6.93


-



0.56


3.20


4.18


5.40


0.56


2.63


0.98


1.22


1.53


0.01


0.06


0.08


0.11


0.14


0.01


0.06


0.07


0.10


0.12


(22.71)


(85.88)


23.22


29.02


36.27


24


Declining growth
period


















2015

2016

2017

2018

2019

2020

2021

2022

2023











9.00%

6.00%

3.00%

2.82%

2.82%

2.82%

2.82%

2.82%

2.82%

7.5%

7.5%

7.5%

7.5%

7.5%

7.5%

7.5%

7.5%



13.7%

13.7%

13.7%

13.7%

13.7%

13.7%

13.7%

13.7%


8.7%

8.7%

8.7%

8.7%

8.7%

8.7%

8.7%

8.7%


13.4%

13.4%

13.4%

13.4%

13.4%

13.4%

13.4%

13.4%






















1.6%

1.6%

1.6%

1.6%

1.6%

1.6%

1.6%

1.6%


2.0%

2.0%

2.0%

2.0%

2.0%

2.0%

2.0%

2.0%


11.7%

11.7%

11.7%

11.7%

11.7%

11.7%

11.7%

11.7%






















2015

2016

2017

2018

2019

2020

2021

2022

2023












2,325.73


2,465.27

2539.233151


2,610.84


2,684.47


2,760.17


2,838.00


2,918.04


3,000.32


175.18


185.70


191.27


196.66


202.21


207.91


213.77


219.80























203.06


215.24


221.70


227.95


234.38


240.99


247.79


254.77



186.29


203.06


215.24


221.70


227.95


234.38


240.99


247.79




16.77


12.18


6.46


6.25


6.43


6.61


6.80


6.99























312.20


330.93


340.86


350.47


360.35


370.52


380.96


391.71



286.42


312.20


330.93


340.86


350.47


360.35


370.52


380.96



25.78


18.73


9.93


9.61


9.88


10.16


10.45


10.74



39.14


42.66


45.22


46.58


47.89


49.24


50.63


52.06




64.92


61.39


55.15


56.19


57.78


59.40


61.08


62.80













93.50


112.12


129.66


134.22


138.00


141.89


145.90


150.01













2015

2016

2017

2018

2019

2020

2021

2022

2023


93.50


112.12


129.66


134.22


138.00


141.89


145.90


150.01



7.62


8.12


8.38


8.64


8.90


9.17


9.45


9.74



6.93


7.62


8.12


8.38


8.64


8.90


9.17


9.45




0.69


0.50


0.27


0.26


0.26


0.27


0.28


0.29



0.15


0.16


0.17


0.17


0.18


0.18


0.19


0.19



0.13


0.14


0.15


0.15


0.16


0.16


0.17


0.17



94.05


112.47


129.78


134.32


138.11


142.00


146.01


150.12













25


CARACO PHARMACEUTICAL LABS
(CPD)



May 14, 2010




Note: Blue numbers indicate numerical input by user







Valuation




Date of valuation

5/14/10







Capital costs

Assigned

Reported

Source for reported figure

Risk
-
free Rate

4.43%

4.43%

Rate decided upon in class

Equity

risk premium

5.17%

5.17%

Rate decided upon in class, Historical Risk
Premium, since 1929, on 20 year bonds (geometric
average)

Beta

1.95

1.95

source: Yahoo Finance

ke

14.5%



kd

6.37%

6.37%

Source: 2009 10
-
K notes to financials

Effective tax rate

11.7%

11.7%

source: taxes divided by pre
-
tax income.
Average of last four years.

After
-
tax kd

5.6%







Debt value estimate: book value (Millions)


15


15

source: 2009 balance sheet: long term debt
plus other long
-
term liabilities

Current market

value





Number of shares outstanding (Millions)

40.576

40.576

source: 2009 Income Statement


Price

$6.05

$6.05


Equity value (Millions)


245



Total value


261



Debt ratio

5.87%



Equity Ratio

94.13%



WACC

13.95%


Formula: WACC = (D/
V)kd(1
-
t) + (E/V)ke, where
V=D+E. Market values should be used.





Forecasts





2010

2011

2012

FCFF


(23.26)


(88.46)


22.31

FCFE


(22.71)


(85.88)


23.22

Valuation




Date of first CF forecast

1/1/10



Days until first cash flow


(133)



Terminal growth rate assumption

2.82%




FCFF

FCFE


Cost of capital

13.95%

14.5%

Brought down from above

Cash flow in 2022


150.01


150.12


Terminal value at 2022

$1,386

$1,320

Constant growth model: V = CF(1+g)/(k
-
g)

Present value of Terminal
Value

$303

$273

Cash flows are discounted to 2009

Present value of intermediate CF


317


308

Ditto

Total

$620

$581


Add Cash


65


65


Subtract value of debt


15




Equity value

$670

$647


Shares outstanding


40.58




Value per share

$16.51

$15.94


Current Price

$6.05


source: Yahoo Finance 5/13/10





19

*











2013

2014

2015

2016

2017

2018

2019

2020

2021

2022


27.89


34.87


93.50


112.12


129.66


134.22


138.00


141.89


145.90


150.01


29.02


36.27


94.05


112.47


129.78


134.32


138.11


142.00


146.01


150.12






19

* High terminal growth rate assumption (4.43%) = Value per share of $17.91.


26


Sensitivity Analysis

and
D
iscussion of DCF


Starting with the low terminal growth assumption of 2.82% and subsequent
valuation of $16.51, the following manipulations were performed and per share values
obtained:

Manipulation

Share Price

Change beta to 1.0.

$33.51

Use a high terminal growth value
of 4.43%.

$18.11

Replace average growth (80%) year with a second low growth (
-
5%) year

$6.42

Increase debt level 10 fold

$15.72

Increase gross capital expenditures 10 fold in 2010

$16.15



The primary conclusion from the DCF model and the subsequent sensitivity
analysis is that the stock is undervalued. In fact, the only way to generate a model that
implies that CPD is fairly valued is by assuming two consecutive years of negative
growth (20
10 and 2011).

The other manipulation that drastically altered the valuation was to decrease
beta. Notably, this increased the valuation. A lower beta is arguably justified because
CPD’s current beta of nearly 2 is not likely to be maintained in the long
-
r
un, since most
large competitors have betas that are below 1
20
. As expected, decreasing CPD’s beta to 1
nearly doubled the stock price. This was expected because CPD is almost entirely equity,
hence a change in beta will have a nearly proportional effect on

the valuation.


No other reasonable manipulation significantly altered the valuation.





20

Yahoo Finance. Retrieved June 5, 2010. <

http://biz.yahoo.com/p/512conameu.html
>.


27



Analyst Opinion


Caraco is only followed by a single analyst,
according to Yahoo Finance
,

and no
analysts according to S&P
21
. Nevertheless,

many proprietary reports concerning the
company can be purchased
at

Yahoo Finance
22
. According to MarketWatch, the analyst’s
current opinion is a

buy

,
23

however, the identity of the analyst is not revealed.


A m
ore detailed discussion of CPD and its prospects can be found on
the
financial
blogs. Notab
ly, every recent blog post pertaining

to CPD
that was discovered during this
research project
was in favor of buying the stock.
For example an article on
www.gurufocus.com

stated:

“We believe the company is worth a large multiple of its
current price. For a company making you $30 million in cash and growing at a 20% clip,
let’s put a 15x multiple on it. That will get us to a $4
50 million market cap, a 2.5x return
from current price.”
24

Another example

on the Motley Fool is the
following: “
Sound
fundamentals, controlled by a deep
-
pocket parent (Sun) that badly wants to be in the US
market and needs CPD's marketing arm. CPD's PPS
has been depressed due to
continuing questions about its US manufacturing operations. When those issues are
resolved, look for a quick pop; until then, almost no downside risk.”

And a third opinion
on Seeking Alpha
declares:


With a large number of produc
ts recently and soon to be
released Caraco is a fast growing company with large potential trading at reasonable
levels. Caraco has the tools and the backing to compete larger firms on a large scale.
With a strong balance sheet and adept management, Caraco
has the potential to take
advantage of various opportunities and reward shareholders in the long run.
25



Additional opinions can be found online that agree with the aforementioned
views and support the belief that CPD is undervalued.







21

Standard and Poor’s. Retrieved June 5, 2010.
http://www.netadvantage.standardandpoors.com.proxy.lib.pdx.edu/NASApp/NetAdvan
tage/cp/companyEstimates.do
.

22

Yahoo Finance. Retrieved May 29, 2010.
http://finance.yahoo.com/q/rr?s=CPD+%27Research
.

23

MarketWatch. Retrieved May 29, 2010.
http://www.marketwatch.com/investing/stock/CPD/analystestimates?subview=ratings

24

Gurufocus. Retrieved May

29, 2010.
http://www.gurufocus.com/news.php?id=85630
.

25

Seeking Alpha. Retrieved June 5, 2010. <

http://seekingalpha.com/article/61962
-
caraco
-
pharmaceutical
-
laboratories
-
fast
-
grower
>.


28


Recommendation

Caraco pharmaceuticals (CPD) is a distressed security that the market has
recently punished for minor FDA violations and a year of underperformance.
My

free
cash flow valuation obtai
ns a target share price of $16.5
1, more than three times the
current marke
t price
,

even with
very conservative growth assumptions
.
Furthermore,
CPD has several huge advantages that I believe are underappreciated by the market: 1) it
is a subsidiary of the 5
th

largest pharmaceutical company in India, 2) it has a diverse
product l
ine and many new drug applications submitted to the FDA, 3) it has a very lo
w
amount of long
-
term debt. CPD’s
stock price has steadily appreciated since the
announcement of the FDA action

(Figure 8)
.






In summary
,
based
up
on my analysis of
CPD
, I recommend that the Portland
Society of Financial Analysts portfolio acquire 300 shares of Caraco Pharmaceuticals,
LTD. (CPD) at the current share price of $6.05.




Figure 8. Recent CPD Stock Movement.