Diagnose Endo's Health Before You Invest

NEW YORK (TheStreet) -- Some companies can't seem to get out of their own way. This has always been my biggest issue with Endo Health Solutions (ENDP), a company I've consistently wanted to like. Too bad Endo hasn't been an easy company to understand.

While doing extraordinary well as a specialty drug company, outperforming rivals like Forest Labs (FRX) and Teva Pharmaceutical (TEVA), Endo's management decided it was time to shake things up to generate more growth. To diversify the business into such areas as services and medical records, management took on additional debt to acquire American Medical Systems, a move that over-leveraged the company.

To enter this already-established market, Endo's higher-ups decided to look for acquisitions while forfeiting a strong cash-flow-generating drug business. The services and medical records sector was highly competitive and dominated by giants like Johnson & Johnson (JNJ) and Abbott Labs (ABT). Endo overestimated its abilities while discounting what it already had.

A series of unfortunate events ensued. Not only did Endo fail to meet its 2012 earnings guidance, but warned that 2013 revenue and earnings-per-share targets would fall short. There was also the dire issue of Endo's portfolio of drugs, many of which were facing expiring patents, which left investors questioning the company's long-term health.

In an unsurprising move, Endo announced the departure of CEO David Holveck, who left in March of this year, almost 18 months before his contract expired. The Street welcomed the news. Shares went higher even though analysts had just downgraded the stock given the poor outlook for generic drugs. Miraculously, all of these issues are now resolved. At least it appears that way.

Endo shares are soaring to all-time highs following yet another acquisition, under the management of new CEO Rajiv De Silva. Last week, the company announced that it had reached a definitive agreement to acquire Canadian specialty drug company Paladin Labs for $77 per share, amounting to a 20% premium, or $1.6 billion.

Did Endo overpay? The most significant question is how Paladin changes Endo's future, which was in decay until a couple of months ago. Here's management's take on the transaction:

"The acquisition of Paladin Labs accelerates Endo's transformation from an integrated health solutions company to a top-tier global specialty health care leader. Together with our sharpened focus, lean operating model and improved execution within our core businesses, strategic acquisitions will continue to play a key role in maximizing our growth potential and cash flow generation to drive future value for Endo shareholders."

That's all well and good. But it's also textbook acquisition-speak. Endo's problem has always been execution. The strong run-up in the stock looks to me like a case of counting your chicks before they hatch. Let's not forget, Endo's third-quarter results, which produced a 5% year-over-year revenue decline, didn't impress.

Endo investors may point to that 11% jump in Endo's Qualitest business, which topped consensus estimates convincingly. While true, the 2% decline in the AMS segment, which missed consensus estimates by 7%, didn't exactly erase ghosts of failures past (not to mention the 18% revenue decline in its women's health department).

I will concede that Endo's new management deserves the benefit of the doubt to right this ship. My problem is with the sudden exuberance in this stock's performance. We've been here before. But this time, Endo must not only synergize this deal, which should take (at least) a couple of years, but management must also address the floodgates of generic drugs that will soon be on the attack as patents continue to expire.

These aren't easy challenges to overcome, especially in an arena like cutting-edge health care. And I don't believe Paladin immediately solves these problems. With the stock now trading at around $60 per share, investors should be very cautious. I would take some off the table and look into better-managed rivals like Abbott Labs and Pfizer (PFE), which are both less risky and offer decent yields.

That said, should Endo fall below $50, I might reconsider.

At the time of publication, the author held no position in any of the stocks mentioned.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

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