Q2 2010 Results
First quarter net sales were $8.87 million, up 23% year-over-year and were aided by the third quarter 2009 introduction of the Brovex line. Second quarter net sales of $4.36 million fell roughly 50% sequentially and were down 33% year-over-year.
The launch of Cedax during the second quarter 2010 provided what we believe was a modest contribution to revenue in the quarter but was insufficient to offset significantly lower sales of the Aldex and Pediatex products, of which Pernix Therapeutics (PTX) launched authorized generics. The discontinuation of Z-Cof 8DM in early 2010 also impacted sales growth in the most recent quarter as the drug generated $7.8 million in gross revenue in 2009.
While sales were somewhat disappointing in the quarter, we do not expect this to be a long-term trend going forward. Management noted that Cedax sales were stronger than expected (as a reminder management’s prior guidance was “at least $12 million in the first twelve months on the market”), and we expect the drug to be a huge catalyst in driving high double-digit sales growth over the next several years.
Second quarter net sales were also negatively affected by a significant surge in Medicaid rebates which equaled 33% of gross product sales, compared to 10% in the prior-year quarter and 12% in the first quarter 2010. The spike in the Medicaid rebate was not entirely unexpected, and was partially a result of the introduction of Cedax, which historically has an extraordinarily high exposure to Medicaid customers. A recent 2% hike in the federal Medicaid rebate as well as substantially higher state supplemental rebates also contributed to the Medicaid rebate hit that Pernix took during the quarter.
Management is working on plans to substantially reduce its overall exposure to Medicaid and lessen the impact from these rebates –- this likely includes some modification to their product line. They noted on the earnings call that they expect their exposure to these rebates to be substantially more muted as they enter the cough/cold season.
We calculate the y-o-y increase in Medicaid rebates cost Pernix almost $0.03/share in earnings in the quarter which is highly material, especially when considering EPS came in at only $0.01. As the company grows sales and gains significantly greater operating leverage, the impact from Medicaid rebates will certainly be much less meaningful to the bottom line. Nonetheless, we feel it is critical that management minimizes its exposure to exorbitant rebates in the future in order to maximize profitability.
This will be something to keep an eye on, especially as sales of Cedax (with its historically high exposure to Medicaid) begin to account for the majority of gross product revenue, which we think could be as early as 2012. Our model incorporates the assumption that Pernix’s exposure to these rebates is moderately high during Q3 and runs in the mid-teens (% of gross product sales) over the next several years — slightly scaling up with the growth of Cedax.
The company hired 25 new sales reps during the second quarter 2010, pushing the total sales team to 57 in anticipation of the full roll-out of Cedax and the entry into new geographic regions. This had the effect of pushing selling expenses up to almost 16% of gross product sales, compared to 13% in the prior-year comparable quarter. We expect Pernix to realize some leverage on this expense going forward as initial ancillary expenses related to hiring of the new sales team members are absorbed and these reps become profitable, likely towards the back-half of the busy winter season.
General and administrative expenses were also materially higher due to the addition of management personnel and professional fees. As we outline in our report, we expect Pernix to have ample opportunity to gain significant leverage on the G&A line over the long-term, and expect to see benefits from this as early as the end of the current year.
Finally, R&D and amortization expenses were also substantially higher in the most recent quarter, largely as a result of the amortization of development expenses (related to new deals with Macoven and Kiel which run through R&D) and the initial amortization of the portion of the Cedax purchase price that was allocated to intangible assets (~$3.9MM over 8 year life).
The net result of lower net sales and higher operating expenses (slightly offset by product margin of 90% versus 88% in Q2 2009) was EPS of $0.01 in the second quarter compared to $0.14 in the prior year period.
Pernix exited the quarter with $11.4 million in cash.
Recommendation / Valuation
We believe Pernix represents an attractive investment based on our belief that the shares are undervalued by over 50%. We model EPS of $0.39 for the full year 2010, down 10% from the $0.43 posted in FY2009. We note, however, that 2010 is somewhat of a transition year for Pernix during which the company is shifting away from more piecemeal products (i.e. – Aldex, Brovex, Pediatex) to drugs that hold more longer-term upside potential (i.e. – Cedax).
The return on this transition should be almost immediate, with robust annual EPS growth expected to begin in 2011 when we model Pernix to generate EPS of $0.75. Pernix is actively seeking to reinvest its huge and growing cash balance, which could result in even greater rate of revenue and earnings growth relative to our forecast.
The shares currently trade at $3.06, implying a 2011 P/E of 4.1x. We believe this cheap valuation may be largely a result of the market “not seeing the forest for the trees” with undue concern placed on choppy quarterly results. As we explain in our 19-page report on the company (for access, see below), Pernix’s competitive advantages rely on the company’s ability to be highly dynamic in an attempt to maximize long-term growth. Management is clearly focused on maximizing the long-term growth of the company so we have little concern over “adjustments” in the business that may result in irregular short-term results but that benefit long-term success.
Peer 2011 P/E comps in the specialty pharma space are largely grouped between 6x – 9x, implying a valuation of Pernix between $4.50 – $6.75/share. Based on our expectations of 4-year EPS CAGR of 41%, we believe Pernix warrants a valuation at the upper end of this range. We also believe Pernix’s numerous competitive advantages, along with the large and growing cash balance, substantially mitigates any downside risk.
We are initiating coverage of Pernix Therapeutics with an Outperform rating. We value the company at $6.75/share, based on 9x our 2011 EPS estimate of $0.75.