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|  | NOVEMBER 1, 2005
 FOCUS STOCK By Cameron Lavey Endo: The Pain and the GainWhat's not to like about this pharmaceutical outfit's brimming pipeline, locked-in market, and what S&P sees as its undervalued stock?As the population ages, we expect an increase in demand for pain-management therapies for both chronic conditions and surgical procedures. Standard &Poor's Equity Research thinks Endo Pharmaceuticals Holdings (ENDP ; recent price, $26.53), a leading provider of pain-management drugs, will benefit from the growth we see in this market, and we forecast midteens revenue and earnings growth over the next several years. In the near term, we expect continued strong results based primarily on sales of Lidoderm and oxycodone. Over time, we think Endo's pipeline drugs and additional research and development efforts will provide longer-term revenue and earnings growth. In our view, the cash generated from sales of oxycodone will enable the expansion of drug-development efforts and broaden the product portfolio. WIDER MARGINS. We forecast revenue growth of about 36% in 2005, with growth slowing to 7% in 2006. The addition of oxycodone sales in the second half of 2005, coupled with the expiration of 180-day exclusivity, distorts results somewhat, in our view. We believe that Endo will continue to effectively manage its selling, general, and administrative (SG&A) expenses while building its sales force. EBITDA margins should widen in 2006 due to cost-containment strategies, coupled with lower SG&A expenses as a percentage of sales. Given our positive view of Endo's growth prospects, we have a 5 STARS (strong buy) recommendation on the shares. GENERIC RELIEF. Branded products accounted for 69% of sales in 2004, with generics accounting for the remainder. The company estimates that the total market for pain-management pharmaceuticals, excluding over-the-counter products, totaled $18.9 billion in 2004. Endo's primary branded products include Lidoderm, Percocet, Frova, and DepoDur. In the first nine months of 2005, sales of Lidoderm, a patch used to treat the pain resulting from postherpetic neuralgia, totaled $288.9 million, up 39% from 2004. Sales of Percocet, a combination of oxycodone and acetaminophen, rose 15%, to $81.0 million. Frova, a migraine treatment, was licensed from Vernalis in 2004, and began selling Frova in the third quarter of 2005. DepoDur is indicated for epidural administration following major surgery. The outfit's generic products are led by oxycodone, a generic version of Purdue Pharma's OxyContin. Endo launched four strengths of oxycodone in June, 2005, and recorded sales of $78.5 million in the first four months following the launch. While several competitors also market generic OxyContin, we think Endo's niche focus on pain management and physician relationships will enable it to maintain a leading market share for oxycodone. Other generic products include Endocet (the company's generic version of its own Percocet), morphine sulfate, and others. FULL PIPELINE. While we expect the company's current product offerings to drive growth in the near term, we think Endo's pipeline portfolio of eight mid- to late-stage products will contribute significantly to future growth. The company received an approvable letter for oxymorphone ER and IR in October, 2003, and expects to complete its response to the FDA in early 2006. We forecast oxymorphone sales of $12 million in 2006. Endo is currently testing two existing products, Frova and Lidoderm, for additional indications. Frova is in Phase III testing for menstruation-related migraines, while Lidoderm is in Phase II testing for lower back pain. Overall, we expect the launch of six new products over the next four years. In addition to current and pipeline products, we think Endo will continue to pursue additional product-development and -licensing opportunities. As of Sept. 30, it had approximately $410 million in cash and cash equivalents and no debt. We expect Endo to use its strong balance sheet and future cash flows to expand the product portfolio. BACK ISSUES. We believe that the overall pain-management market offers a large and attractive opportunity. According to IMS Health, the prescription pain market totaled about $18.9 billion in 2004, with opioid therapies making up about one-third of the market. Opioid medications have grown at a compound rate of 20% over the last five years, while non-opioids grew at 14%. We project total sales of $837 million in 2005, rising to $895 million in 2006. Our projections include Lidoderm sales of $409 million in 2005 and $475 million in 2006. In our view, Lidoderm's success will be a key factor for Endo in 2006. Prescription growth for Lidoderm was up 35% in the third quarter of 2005, providing support to our belief in the strong demand for the product. Our forecast assumes a mid-single-digit price increase for Lidoderm in 2006 and gross margins of 86%. We also think that recent negative publicity surrounding COX-2 inhibitors such as Merck's (MRK ; 3 STARS, hold; $27) Vioxx and other NSAIDs, is benefiting sales of Lidoderm. In August, Endo reported positive results from the first of two Phase III clinical trials for oxymorphone ER. This data was supported by results from the second trial, which were released in October. In the first trial, the safety and efficacy of oxymorphone ER were compared with placebo in 205 patients with moderate to severe lower back pain. Results of the study, which were released ahead of our expectations, demonstrated a statistically significant difference in reduction of average pain intensity. Based on the results of these two studies, we expect Endo to file an NDA with the FDA early in 2006 and to begin marketing oxymorphone ER in the third quarter of 2006. EXPANDING LINE. Going into 2006, we think it will become increasingly important for Endo to reduce its dependence on Lidoderm and oxycodone. We anticipate generic challenges to Lidoderm sometime in 2008 or 2009. However, at that point, we expect Endo to have broadened its product portfolio via the successful introduction of current pipeline drugs, as well as potentially acquiring or licensing additional products in the future. In 2005, we look for gross margins of 78.9%, EBITDA (earnings before interest, taxes, depreciation, and amortization) margins of 42.8% and operating EPS of $1.64. In 2006, we see gross margins narrowing to 74.2% due to product mix shifts and increased competition. However, due to lower SG&A and R&D expenses as a percentage of sales, we think EBITDA margins will widen to 43.5%, resulting in EPS of $1.74. Our 2006 EPS forecast includes estimated stock option expense of 6 cents per share. Based on Standard & Poor's Core Earnings methodology, we estimate S&P Core EPS of $1.57 for 2005. Our Core EPS estimate includes stock-based compensation expenses of about $9 million, or 7 cents per share. In our opinion, the divergence between Endo's Core and operating EPS is in line with other specialty pharma companies in our coverage universe. Our 2006 operating EPS estimate of $1.74 includes a stock-compensation expense of 6 cents, and therefore our Core EPS estimate for 2006 is also $1.74. GOVERNANCE ISSUES. Our 12-month target price of $35 implies over 30% potential upside from current levels, and is supported by our discounted cash flow model as well as our peer group analysis. Our discounted cash flow model incorporates a weighted average cost of capital of 10%, 20% free cash flow growth in 2005 (from a base of $163 million) trending down to 3% in year 15, and terminal growth of 3%. Our target price implies that the stock will trade at about 20 times our 2006 EPS estimate of $1.74, in line with peers. The shares currently trade at about 15 times our 2006 EPS estimate of $1.74, a discount to the peer average of 20 times and in line with the S&P SmallCap 600 multiple. Endo's corporate governance practices have a mixture of positive and negative aspects, in our view. The board is controlled by a majority of independent directors and the full board is elected annually. A simple majority vote of shareholders is required to amend the charter or bylaws and to approve a merger. In addition, all directors with more than one year of service own stock in the company and all stock-based incentive plans have been approved by shareholders. REGULATORY COMPLICATIONS? On the negative side, both the nominating committee and the compensation committee include affiliated outsiders. Shareholders do not have cumulative voting rights in director elections. Risks to our recommendation and target price, in our view, include generic competition for Endo's branded products, particularly Lidoderm, as well as the potential for the FDA to reject pending and future drug applications. Delays in the regulatory process could slow Endo's revenue growth. In addition, the FDA has recently stepped up its review of oral opioid medications in an attempt to confirm the risk/reward profile of such pain-management therapies. Any scrutiny of Endo's products could lead to delays or outright rejections.  Analyst Lavey follows shares of pharmaceutical research and development companies for Standard & Poor's Equity Research Services All of the views expressed in this research report accurately reflect the research analyst's personal views regarding any and all of the subject securities or issuers. No part of analyst compensation was, is or will be, directly or indirectly related to the specific recommendations or views expressed in this research report. Standard & Poor's Regulatory Disclosure Any advice, analysis, or recommendations contained in articles labeled "Insight from Standard & Poor's" reflect the views of Standard & Poor's, which operates separately from and independently of BusinessWeek Online. It is possible that BWOL may from time to time publish information that is not consistent with advice, analysis, or recommendations that are published by Standard & Poor's. Standard & Poor's and BusinessWeek Online are each units of The McGraw-Hill Companies, Inc.
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