Riffing the Competition

When you have a run-of-the-mill headache or cold, you take an aspirin or an antihistamine which you most likely picked up off a shelf at your pharmacy. You don't see a doctor, you don't have to talk to the pharmacist and you definitely don't need a prescription for an over-the-counter (OTC) medication, some of which you might even take on a daily basis.

According to a paper from the American College of Preventative Medicine released in 2011, more than $17 billion of OTC products were sold in 2010 and more than a third of American adults reported using OTC medication on a regular basis. A survey conducted in 1999 showed that nearly 20 percent of the population used an OTC pain medication in any given week.

While there is the risk that readily available medications may be misused, OTC products are commonly used because they allow fast and direct access to effective medication for a whole host of common ailments. They also have the added benefit of helping to reduce the pressure on our health care system by preventing needless doctor calls.

When you think of OTC medications many of the first to come to mind, such as Tylenol, Sudafed and Benadryl, are products made by Johnson & Johnson (NYSE: JNJ). But over the past decade – especially since the turmoil of the Great Recession – there has been a rise in "generic generics," otherwise known as store brands.

Most OTC medications have been around for decades, in the case of aspirin more than a century, and as a result have virtually no patent protections. That means that competition in the space has always been fierce and most manufacturers invest heavily in building up brand reputation for effectiveness, making it a relatively low margin business to begin with.

The market has become even more competitive since retailers have realized that they can keep more money in their own pockets by contracting for the production of virtua! lly identical products which can be sold under their own label. For instance, if you walked into a pharmacy operated by Walgreen Company (NYSE: WAG) or a Kroger (NYSE: KR) grocery store, you'd find products ranging from green beans to acetaminophen bearing their own name. And in the case of acetaminophen you might even find a label on its box that says something to the effect of, "compares to the active ingredient in Tylenol."

That creates a serious headwind for Johnson & Johnson's products, since the store brand versions are typically more than 20 percent cheaper than the branded versions. A recent working paper from the University of Chicago also shows that 72 percent of educated consumers – doctors and pharmacists – purchase store brands rather than name products. Research from the Private Label Manufacturers Association also shows that 91 percent of consumers who purchase a store brand will stick with a store brand.

Those factors are already influencing the way many makers of OTC products are doing business. In the case of Johnson & Johnson, that has resulted in a shifting emphasis on proprietary branded drugs and medical devices over the past several years.

But while makers of branded products are facing headwinds, makers of store brand products are booming.

Perrigo Company (NYSE: PRGO) is the world's largest manufacturer of private label OTC pharmaceuticals. Its products range from pain killers and cold remedies to pet care products. It is also the only private label infant formula maker to have Food and Drug Administration approval. It also makes a host of generic pharmaceuticals available only by prescription, primarily topical creams and ointments, and manufactures active pharmaceutical ingredients for sale to outside companies. In all, it markets more than 3,000 products.

Since 2009, the company has grown its annual revenues by 106 percent to more than $4 billion. Over the same period, earnings per share (EPS) has grown from $1.54 to $4.! 68 in its! latest fiscal year which ended last June. Analysts estimate that EPS should come in around $6.74 in this fiscal year and $7.82 next year, averaging better than 14 percent growth over the next five years.

From a competitive perspective, Perrigo enjoys a number of advantages.

First, it has been very shrewd in its acquisitions. It gained access to the infant formula market (and its FDA approval) through its purchase of PBM holdings and its buyout of Sargeant's, one of America's oldest manufacturers of pet supplies, propelled it to the top of the store brand pet care market.

It also benefits from the fact that it has to do relatively little marketing of its own. While it actively supports the marketing efforts of its private label clients, they bear most of the advertising burden of making consumers aware of the product and educating them on its effectiveness. That helps keep its margins in excess of many of its consumers, with gross margin running at about 35 percent over the past few years with net margins in excess of 12.5 percent. Free cash flow also runs at more than 12 percent of sales.

The company’s vertical integration is also a huge help when it comes to margins, since it manufactures many of its own active ingredients. Its 23 production sites on three continents and breadth of product offerings also help it to keep manufacturing and transportation costs down.

Those advantages coupled with a prudent acquisition strategy and the continued growth in private labels all add up to long-term growth potential for Perrigo.

Perrigo is an attractive buy up to 155.