Akorn On Track

Management plans to file its 10-K by the May 9 financial reporting deadline, which should remove recent delisting fears on the stock. In the meantime, Akorn's product portfolio and pipeline should be able to keep the company's performance mostly on track with our expectations. Complete response letters from the Food and Drug Administration on approximately 50 of the company's 87 generic drug applications have somewhat slowed its pace of new applications, but we anticipate that its investments, including likely higher research and development spending as a percentage of sales, can uphold the firm's position in the more attractive complex generic product categories. Management estimates that nearly half of the drugs with complete response letters could receive approval over the next year. Also, management doesn't anticipate an inspection of its India facility by the FDA until mid-2018, which is slightly behind our initial expectations but not a critical factor in our longer-term forecasts.

We See Rapid Growth Continuing in Near Term but Eventually Slowing Since taking over in 2009, CEO Raj Rai has transformed Akorn from a small, overly diversified, unprofitable pharmaceutical and diagnostic company into a highly profitable niche generic manufacturer. While generics are not typically an attractive business, management has wisely used acquisitions (including Hi-Tech and VersaPharm) to increase Akorn's scale and concentration in niche markets such as injectables, ophthalmology, and topical creams, where barriers to entry are higher. Manufacturing complexities and tougher regulatory restrictions in these markets lead to fewer generic competitors than the traditional simpler-to-manufacture pill markets, creating attractive returns on invested capital despite the commoditylike nature of the business.

Given Akorn's small size relative to the market opportunity and its backlog of abbreviated new drug applications, we expect the firm's rapid growth to continue in the near term, both organically and through acquisitions. Longer term, however, we see potential challenges due to the complexities surrounding current blockbuster ophthalmology drugs, which will probably limit Akorn's ability to bring generic competition to the most lucrative product opportunities. Historically, the largest ophthalmology drugs were glaucoma eye drops such as Xalatan, which Akorn has been able to replicate. However, more recently, we have seen new branded products increasingly shift toward biologics (Lucentis, Eylea) and even implantable devices (Allergan's Ozurdex and Xen gel stent), which will be extremely challenging for Akorn to replicate. In the acute-care market--including allergy, antibiotics, and anti-inflammatories--where Akorn primarily operates, we see less favorable long-term market growth rates.

Moat Comes From Capacity for Complex Manufacturing We award Akorn a narrow economic moat due to its niche manufacturing capabilities in injectable, ophthalmology, topical creams, nasal spray, and over-the-counter drugs, which have higher barriers to entry than most conventional generic pill markets. Since many generic drugs have no product differentiation, we generally award economic moats in this commoditylike industry for cost advantages from economies of scale and vertical integration. However, complex generics, which include many of the product categories Akorn competes in, have more difficult manufacturing processes and regulatory hurdles that help limit competition and uphold pricing and margins. Injectable and ophthalmology drugs, for example, require sterile manufacturing processes, while topicals and nasal sprays also generally have more complicated formulations.

Additionally, while most generic drugs can prove bioequivalency through simple blood tests, eye and topical generic drug approvals require small clinical trials because of more difficult-to-evaluate locally administered effects. These trials raise generic drug development costs, keeping many smaller players out of the market. Major generic manufacturers in topicals and ophthalmology drugs, such as Perrigo PRGO and Akorn, post gross margins close to 60% and operating margins close to 40%, which compares favorably with 50% gross and 20%-30% operating margins seen at competitors with manufacturing operations in more conventional pills.

Accounting Concerns Linger Although an attractively positioned niche generic drug manufacturer, Akorn faces risk of competition from larger peers with considerable economies of scale, such as Teva TEVA or Mylan MYL, looking to enter higher-margin segments of the industry. The company plans to shift manufacturing to lower-cost regions, including India, but regulatory delays and inspections could delay its growth and margin expansion. Akorn is fairly diversified and has not seen major manufacturing issues, but many peers, particularly in sterile injectable drugs, have seen headwinds from regulatory concerns that have caused short-term disruptions.

Management has until the middle of 2016 to get caught up on delayed Securities and Exchange Commission filings and avoid being delisted from the Nasdaq. We think Akorn can eventually move beyond its accounting issues and file restated financials before the deadline, but its recent decision to switch independent auditors raises some concerns.

Akorn leveraged up to complete the $640 million acquisition of Hi-Tech and $440 million acquisition of VersaPharm, but we believe its debt load of approximately 3.5 times debt/EBITDA is manageable. Given the reliability of its sales, we do not anticipate Akorn will have any issues meeting its obligations.