Thursday morning a Court of Appeals ruled that Medicines Company’s (MDCO) patents on Angiomax were invalid. Surprisingly, this decision has been heralded by sell side analysts as a good thing, removing an “overhang” on the stock. Indeed, the stock jumped 10% on Thursday after the decision was released. But removing an overhang by realizing the worst case scenario doesn’t seem a rational reason to justify an increased outlook or market cap. 

Indeed, the Court of Appeals decision is worse than the previous decision against MDCO, which had held that MDCO’s patents were valid, but not infringed by Hospira’s (HSP) proposed generic. Had that decision been affirmed, it would have been a loss, but one that only allowed HSP to enter the market by offering a generic competitor (because the patents would still be valid to stop other generics). However, with the decision Thursday, the patents are no longer valid to assert against any generic, including Mylan (MYL) (which had lost its case against MDCO at the district court last year). I expect several generics to enter the market quickly, which will cause a loss of revenues and margins to MDCO much faster than had HSP entered alone (statistical data show the entry of a single generic does not cause price erosion and loss of market share nearly as rapidly as when two or more generics enter the market).

Several people have mentioned to me that MDCO’s value is now based on its other products, including its pipeline, that analysts had “zeroed” out Angiomax revenues for the second half of 2015 and later. I make no comment about Medicines Company’s other products because they don’t (yet) involve legal disputes. However, all those things were present Wednesday. The only thing different between then and now is the Court of Appeal decision rendering for certain a loss of MDCO’s Angiomax patents. Does that really justify such a material positive reaction? I don’t think so, especially since the decision means MDCO will now have to revert from a company with hundreds of millions in revenues to one based on hope for its pipeline. That seems to make it much more volatile and susceptible to any biotech bubble that may burst.

Oral argument in The Medicines Company's (MDCO) appeal of its Angiomax patent case against Hospira (HSP) took place Friday afternoon. The appeal concerns a Delaware district court decision that two of MDCO's Angiomax patents are not infringed by HSP's proposed generic. The district court reached that decision because it believes both patents require a very specific manufacturing process, one HSP does not use. The district court did, though, find both patents, which extend to 2029, valid. The original Angiomax patent, which expires this June, is not at issue in the case and MDCO has no other patents listed in the Orange Book for the drug.

At Friday's oral argument, the Court of Appeals judges assigned to the case seemed to disagree with the district court's non-infringement decision and instead believed only one of the two patents requires a specific manufacturing process. Using a broader interpretation that does not require a particular manufacturing process, it is likely HSP's proposed generic would be found to infringe the other patent, which would be very good for MDCO, as it need only prove one of its patents is infringed in order to keep HSP's generic off the market.

However, the Court of Appeals judges also found much merit in an invalidity argument raised by HSP, namely that the patented form of Angiomax was sold commercially more than a year before the related patent applications were filed. HSP had raised this issue, called the "on sale bar", with the district court, which rejected it, saying MDCO's relationships with a manufacturer and distributor for Angiomax did not count as commercial sales of the drug. The Court of Appeals judges asked many questions during Friday's oral arguments about the nature and facts of the relationships, indicating they think they could be considered commercial sales. If so, both patents in suit would be invalid.

It's difficult to predict how the Court of Appeals will rule in this case. Two of the three judges assigned are relatively new and none came to the Court with extensive patent or pharmaceutical backgrounds. I expect the case will come down to the "on sale bar" invalidity issue, as it seems quite likely the Court of Appeals judges will reverse the district court's narrow interpretation of at least one of the two patents, making it easy for MDCO to prove infringement of that patent. If, however, the Court of Appeals sides with HSP on the "on sale bar" invalidity issue, then the patents are dead regardless if they are infringed. If the Court of Appeals concludes MDCO's patents are valid, and if they do indeed say at least one was interpreted too narrowly by the district court, they'll then likely send the case back to the district court to consider infringement and invalidity under the new broader interpretation that is not limited to any particular manufacturing process. Only time will tell.

Of note, there is also a pending appeal by Mylan (MYL) of a Chicago district court's decision in favor of MDCO in a later filed Angiomax patent case involving the same two patents. In that case, the Chicago district court disagreed with the narrow interpretation given by the Delaware judge in the HSP case for one of the patents and held MYL infringed it. The Chicago judge agreed, however, with the Delaware judge that both patents were valid. If the Court of Appeals rules the patents are invalid in the HSP case due to the "on sale bar", it will apply that ruling to the MYL case as well, resulting in a reversal of the decision in MDCO's favor there.

I expect a decision from the Court of Appeals in the MDCO v HSP case in 2-6 months.

On this morning's conference call (transcript), Medicines Company (MDCO) President and CFO Glenn Sblendorio discussed in his opening remarks the company's ongoing patent litigation with potential generic competitors to MDCO's top selling drug Angiomax, which accounts for about 85% of MDCO's U.S. revenue:

Now for an update on the ANDA litigation related to Angiomax. As you know in October of last year we won a favorable decision in our litigation with Mylan where the District Court judge in Chicago found that our 727 patent is valid, enforceable, and infringed by Mylan. That decision is on appeal but the schedule for oral arguments has not been set. In the Hospira case, the District Court found in March of last year that our 727 and 343 patents are valid, but based on the claim construction, the court also found that Hospira was not infringing. We are appealing the Hospira decision and oral arguments before the appellate court will be held in early March. We expect the decision anywhere from one to six months after oral arguments.

As Mr. Sblendorio points out, there are two Angiomax patent cases that are currently on appeal. The first case, against Hospira (HSP), resulted in a loss for MDCO at the district court in Delaware. That appeal has been fully briefed and its oral argument at the Court of Appeals is scheduled for March 5. 

The second case, against Mylan (MYL), resulted in a win for MDCO at the district court in Chicago. To be technical, the company won on only one of the two patents it is asserting (the 727 and 343 patents mentioned in the quote above), but both last until 2029, so winning on only one doesn't make much of a difference as far as market exclusivity is concerned. In the HSP case, MDCO lost on both patents.

If the loss to HSP is affirmed, a generic version of Angiomax could be launched as early as June this year. If the loss to HSP is reversed, MDCO could avoid generic competition to Angiomax until 2019, as that is when the company has agreed to allow Teva and APP to enter the market with their generic versions. This of course assumes the MYL decision in MDCO's favor is affirmed. It is possible that the Court of Appeals could reverse the HSP loss but then also reverse the MYL win, meaning MYL could launch a generic as early as June this year, but that possibility is highly remote because the issues in both appeals are substantially similar, even if not identical, so I expect the Court of Appeals will either rule for, or against, MDCO in both. 

Mr. Sblendorio continued in this morning's call to say that, due to the materiality of the appellate court's decision in the HSP case, the company could not provide financial guidance:

We continue to believe that claim construction in the Hospira [case] was incorrectly decided in the District Court and we believe we will prevail. However, given the uncertainty surrounding the outcome of the case, we believe it is better to hold off on providing financial guidance at this point. Once a decision is made in the Hospira case, we will determine if appropriate to provide financial guidance.

Later in the call, in response to a question from Jeremiah Shepard at Credit Suisse, Mr. Sblendorio gave more reasoning for the lack of guidance:

If we are fortunate and are able to keep Angiomax beyond June of 2015, obviously that is very positive for the Company. It shows a whole different revenue growth profile, and in fact things that we would do around cost, we would not do. So whether that’s reduction of headcounts or slowing programs down. In the situation where it was a negative decision, that would trigger obviously other decisions around cost structures and possibly people and deployment of people around different programs. So we feel rather than put out a complex matrix of different scenarios, the best thing would be to wait until we had some clarity and provide that clarity in guidance once we had a decision.

I have been following the Angiomax patent cases for quite some time and am eagerly awaiting the oral argument on March 5, as I expect many are. As for when the Court of Appeals will rule, Mr. Splendorio said they expect a decision within one to six months after the oral argument, an expectation I share. MDCO closed down about 4% today, while PJP and the market were flat.

Some Wiggle Room, Please

Lots of earnings reports out. Let’s go around the horn.

Staples (SPLS) and Office Depot (ODP) will, in fact, join forces. The duo announced February 4th that Staples will pay $6.3 billion for its rival, valuing Office Depot at $11 per share, a nice premium to its previous day close and relative to our fair value estimate. Management expects to generate at least $1 billion in annualized cost savings. Removing redundant overhead, streamlining distribution and carving out other efficiencies will be par for the course. We also think pricing will ease up a bit, though competition from Walmart (WMT) and Amazon (AMZN) will always be present.

We wouldn’t expect Office Depot’s equity to converge to the take-out price until the regulatory review is completed, likely before year’s end. Investors can’t forget, however, that regulators axed this deal in 1997, but that was a long time ago, and the competitive environment was much different. Shares of Office Depot are trading at less than $10 at the moment. We value them at $8 on an individual basis under relatively optimistic assumptions. The market is factoring in a meaningful probability of regulatory road blocks, at least at this time.

In other dealings, Pfizer (PFE) announced that it would acquire Hospira (HSP) for $17 billion, or $90 per share in cash. Hospira closed in the mid-$60s the day prior, so the target’s management negotiated a rather nice deal, in our view, especially in light of our estimate of its standalone value. Hospira is a leader of injectable drugs, infusion technologies, and biosimilars – large and growing categories. Pfizer estimates that the global market value for generic sterile injectables and biosimilars will be $70 billion and $20 billion, respectively, by 2020.

Pfizer’s management had been on the acquisition trail for a while, having been rebuffed numerous times from AstraZeneca (AZN). Pfizer would have paid up for AstraZeneca if the deal had been completed, and we think it has paid up for Hospira as well. Remember, whether an acquisition is accretive or dilutive to accounting earnings per share matters little. In assessing whether a deal is value-creative to the acquirer, one must compare the target’s standalone intrinsic value + the discounted value of future deal synergies with what the suitor paid.

Though Hospira’s growth markets are large and synergies can be had, Pfizer paid well over our estimate of Hospira’s standalone value. The deal price values Hospira at 35+ times 2014’s adjusted earnings of $2.40-$2.50 per share. That’s expensive for a firm growing the top line less than 10%! Should Pfizer’s board be shaken up? Are they being too lax with shareholder capital? The market seems to disagree with us. Pfizer’s shares are up on the announcement.

I like to pay close attention to the building materials firms as they provide insight into a great many other areas of the industrial economy. The #1 maker of gypsum wallboard in the US, USG (USG) reported mediocre fourth-quarter results, with net sales advancing 4% and adjusted net income advancing to $32 million from $22 million in the prior-year’s quarter. Management noted that all of its businesses are heading in the right direction, which we view as a positive data point for much of the commercial and residential construction arenas. USG has tremendous operating leverage in its model, and we think it’s worth paying close attention to. Shares are trading off on the report.

The largest producer of construction aggregates (sand, gravel, crushed stone and the like) in the US, Vulcan Materials (VMC) announced a rather robust fourth quarter. Total revenues advanced 11% thanks to a 15% increase in same-store shipments, to 4.3 million tons. The company’s average sales price increased 2%, despite an unfavorable mix, and its segment gross profit surged 40% in the period. Adjusted EBITDA of $172 was 30%+ higher than last year’s mark. Vulcan’s performance continues to indicate a construction activity recovery, though its shares are quite pricey at ~50 times trailing 12-month earnings. Let’s just say the market is expecting a continued strong recovery at Vulcan to assign it that multiple.

Let’s move on to the reports of a couple high-beta stocks: Michael Kors (KORS) and Under Armour (UA). Both continue to grow like weeds. Though fast-growing operations are certainly positive attributes, such dynamics create an added layer of complexity to the valuation analysis. What is the correct normalized revenue growth number for Michael Kors to use in Year 5 of the valuation process, for example? Is the firm’s correct normalized growth rate 30%, or is it 20%, or perhaps 15% is correct?

The reasoning for using a fair value range in valuation analysis is clear when it comes to high-beta, fast-growers. We can’t possibly peg the company’s normalized growth rate with absolute precision (nobody can), no more than we can predict the future with absolute certainty. We also don’t want to truncate upside potential, no more than we want to ignore downside risks. Thinking about valuation as a range of probable fair value outcomes, or a fair value range, is one of the most valuable approaches you can ever adopt. Being approximately correct in the identification of valuation outliers is the goal of any valuation process, not being precisely wrong.

With all of that said, the Street appears to be overreacting to Michael Kors’ conservative top and bottom-line guidance for the balance of its fiscal 2015. Market observers know that the future outlook always trumps the most recently-reported quarterly results (which are now history), but it’s difficult to truly be disappointed in a firm that is growing the top line at a ~30% clip, the pace of growth achieved during its calendar fourth quarter. Kors’ torrid pace of new store openings (114 net new ones in the quarter), strong e-commerce expansion (+70%) and 8%+ comparable store sales growth are driving such expansion.

The firm’s European growth story, however, is perhaps most impressive. Adjusting for currency, revenue generated in Europe grew more than 85% versus last year’s quarter thanks in part to comparable store sales increases of ~30%+. Very few, if any, firms in our coverage are growing their European operations that quickly. Diluted earnings per share is expected to be in the range of $4.27-$4.30, implying a ~16 times multiple on trailing earnings. For a company that is growing as fast as Michael Kors, a below-market multiple makes very little sense, even with its heightened risk profile. The company’s shares are trading below the low end of the fair value range, and we’re watching them closely.

Under Armour is growing at a similar clip. Net revenues advanced 31% in the fourth quarter, and the firm leveraged such expansion into 37% net income growth. The company’s apparel operations were helped by new offerings across training and hunting, and its footwear offerings continue to gain traction, up more than 50% on a year-over-year basis in the quarter. This is quite a feat given the dominance of Nike (NKE) in this area. Under Armour’s international net sales more than doubled and now account for nearly 10% of the business. Diluted earnings per share for 2014 came in at $0.95, and the firm is targeting operating income growth of 12%-15% in 2015. Consensus is looking for earnings per share just north of $1.20 in 2015, putting Under Armour’s earnings multiple at 60+ times. That’s way too pricey for our taste!

Similar fickle customer bases, similar growth products, and similar intense competition, yet the market assigns Under Armour a multiple (60x) that is ~4 times that of Michael Kors (16x). I think you can see why we think Under Armour is overvalued while Micheal Kors is undervalued. Take a look at their 16-page reports. The market sometimes has a difficult time reconciling such discrepancies. This is one of the key advantages of Valuentum’s birds-eye view. We can call out mis-pricings as we see them. You’ll find the market is not as smart as academia says it is – sorry advocates of EMH.

As for Best Ideas portfolio holdings, Teva’s (TEVA) and PPL’s (PPL) quarterly reports were business as usual. I didn’t see anything wrong with PPL’s quarter and was quite encouraged by management’s confidence in its ability to drive mid-single-digit earnings per share growth through 2017. We’ll re-evaluate our position in shares in the Dividend Growth portfolio as the spinoff of Talen Energy approaches.

I still remember when I received an email from a member a few weeks or so after we added Teva to the Best Ideas portfolio. I think the stock had dropped from $40 to $36 per share over that time – a completely immaterial move – but he felt something was terribly wrong. Shares of Teva, one of the best performers in all of 2014, are now approaching $60 per share, up significantly from the July 24, 2013 “add” price! Our fair value estimate of shares is in the mid-$60s.

Give us some wiggle room, please.

I preach: “Perspective. Perspective. Perspective.” And then I preach: “Patience. Patience. Patience.” And remember the critical formula: materiality + context = experience. Those that are following our investment seminars know what I am talking about. For those that don’t know, I’m always available. I want you to succeed!

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