Frank Voisin writes about value investing topics at http://www.frankvoisin.com
Forest Laboratories, Inc. (NYSE: FRX) is a pharmaceutical company that specializes in therapeutics for the central nervous and cardiovascular systems. The company both develops new drugs through its own research and development (spending on average $808.5 million in each of the last five years), as well as licenses new drugs from third parties. FRX manages a sales force that markets its products directly to physicians.
The company has generated extremely strong returns on equity averaging 22.9% over the last decade. However, this in fact understates the true extent of the company’s performance, as the company tends to carry an extremely high cash balance and portfolio of securities (averaging 64% of equity) with no leverage. Thus, a better metric is to use invested capital as the denominator, and on this basis, the company has an average ROIC of 60% for the decade. The following chart shows the strength of the company’s returns over time.
Despite these strong returns, the company is trading at just 1.6x book value. Given the company’s strong performance, large cash balance and strong free cash flows, I thought it would be worth taking a closer look.
Let’s take a look at the company’s free cash flows.
Here we see the company’s strong cash flows over the last decade, which have averaged $714 million per year. Note that in calculating free cash flow, I’ve subtracted the purchase of patents and trademarks along with PP&E, so my FCF figures might be slightly lower than yours. The company has a market cap of approximately $8 billion, of which nearly $2.9 billion is cash and securities, so $714 million works out to a FCF yield of about 14%.
One thing to note is that, while the company does not pay a dividend, it nevertheless does return a large portion of this free cash flow to shareholders in the form of share repurchases.Since 2004, the company has repurchased $3.96 billion worth of shares, reducing its share count by 23%.
While on the topic of cash, let’s take a look at the cash balance, for some perspective over time.
Note that the company has not utilized debt in its capital structure and that it has been building its cash and securities balance quite consistently. These are things I like in a company.
One important thing to note is that, in February 2011, the company purchased Clinical Data Inc (“CDI”) for $1.3 billion net cash.This is a massive acquisition for the company (the largest in its history) and consumed approximately 1/3 of the company’s cash balance. CDI’s major product is Viibryd, an antidepressant that was approved by the FDA in January of 2011, less than a month before the acquisition. Additionally, CDI had the drug Stedivaze (a coronary vasodilator) in Phase III trials. Since CDI was not generating revenues, it is difficult to make an assessment of this acquisition without a great deal of insight into this market, which I do not possess (if you have any insight here, leave your thoughts in the comments below).
Though the company has a strong balance sheet and has been a consistent performer historically, there are reasons to believe its future may be more volatile and not reflect the past. Over the next few years a number of its drugs come off patent, which is sure to have an effect on the company’s bottom line:
- Daliresp comes off patent in 2015 (though it is eligible for extension for five more years). It only received marketing approval from the FDA in February.
- Lexapro comes off patent in March 2012. It accounted for $2.3 billion of sales in fiscal 2011, or55% of revenues.
- Namenda comes off patent in April 2015. It accounted for $1.3 billion of sales in fiscal 2011, or31% of revenues.
Thus, drugs representing a significant portion of the company’s revenues are going to be subject to increased competition in the near term as these patents expire (and the latter two are apparently not subject to extension). Given the importance of these drugs to the company’s revenues, this will likely have a material impact on the company’s performance. FRX is thus exceedingly reliant on future winners to make up for the declining performance of its past hits, which somewhat explains the massive acquisition of CDI, which is the largest in the company’s history. This reliance on future winners introduces a significant amount of risk.
Given the uncertainty about its future performance once these drugs come off patent, and the company operating in an industry firmly outside of my circle of competence, I will have to pass on FRX despite its strong performance. However, for an investor knowledgeable about this industry, this may present a good value opportunity.
What do you think of FRX?
Author Disclosure: No position.
Talk to Frank about Forest Laboratories, Inc.
Frank Voisin writes about value investing topics at http://www.frankvoisin.com
