Small-Cap Bargain with Big Upside

10/25/2011 9:00 am EST

Focus: STOCKS

Generic drug maker Hi-Tech Pharmacal (HITK) is flush with cash and new drugs in the pipeline but is trading at a low valuation, making it an attractive buy for the aggressive growth portion of any portfolio.

In late August, I wrote an article about my approach to investing that consists of a high-quality core of between 15 and 20 dividend-paying stocks and five to ten undervalued, more speculative companies that represent good risk/reward opportunities. 

Below is an analysis of Hi-Tech Pharmacal (HITK), a stock I believe trades at a significant discount to intrinsic value and is poised for a significant run higher.

HITK is a small-cap biotechnology/pharmaceutical company that manufactures and markets both over-the-counter and prescription generic drugs. I added the stock to my portfolio throughout July and August at an average cost basis of $29.07. 

The stock currently trades at a trailing price-to-earnings (P/E) ratio of 8.7 and only about 12 times next year's earnings estimates. Earnings growth over the past year has been 26.1% with an average earnings growth over the past three years of 110.4%. 

The company has over $62 million in cash on its balance sheet, which represents 30% of its fiscal 2011 annual revenue of $208 million. Apple (AAPL), the "cash king," has 9% cash to revenues on its balance sheet. 

Here is a daily chart:

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NEXT: 2 Primary Risk Factors for This Trade

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What is even more impressive is that the company has quadrupled its free cash flow from $6.1 million in 2009 to $26.2 million in fiscal year 2011 alone.  This combined with no debt and operating margins of 31.42% as compared to a pharmaceutical industry average of 16.67% mean that this company is in a very strong financial position.

HITK?s pipeline also looks strong, as they have 14 products potentially worth about $1 billion in sales awaiting FDA approval and an additional 20 products in development that could bring in nearly $4 billion in future sales. 

With the cash flow they are generating, I would expect more research and development (R&D) investment and look for a strengthening pipeline in the future. And lastly, when looking at insider trading activity, the ratio of current year insider buying to insider selling is greater than 1.5, which provides additional comfort.

Two points of caution, though:

  1. It's a small cap, so by nature it's a bit speculative 
  2. The company relies heavily on its Fluticasone Propionate, a nasal spray that made up approximately half of the company's sales last quarter. Understanding that this has been their star performer, any supply or sales missteps related to this drug could spell trouble.

As a whole, I believe this company meets my "cheap" criteria in having a strong financial position, good revenue growth, and no catalyst necessary for strong stock price appreciation. The stock has also moved above multi-month resistance to new all-time highs, and I believe this one has room to run.

By Joshua Schroeder, contributor, Minyanville's Buzz & Banter

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