Forest Laboratories FRX
December 20, 2004 - 10:26pm EST by
2004 2005
Price: 45.46 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 16,748 P/FCF
Net Debt (in $M): 0 EBIT 0 0

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Forest Labs (ticker: FRX) is more of a Philip Fisher stock than a typical Graham and Dodd stock. After adjusting for about 50% of the cash on the balance sheet which FRX has already announced it will use for share buybacks, FRX offers an opportunity to buy a great company, with solid earnings quality and high ROC (that should be sustainable due to a solid drug pipeline with current branded drugs that are still in the early stages of their patent cycle) for approximately 15.0x forward earnings. FRX offers a chance to buy a pharmaceutical company that is trading for an estimated 90% of intrinsic value based on conservative estimations and giving them no credit for their pipeline or potential market share gains (for current drugs) that they should experience due to the size of comparable branded offerings. I believe that this discount to intrinsic value in conjunction with the fact that current prices give them no credit for market share gains or pipeline potential provides a large enough margin of safety to warrant a purchase.

Forest develops, manufactures and sells prescription and non-prescription drug products to drug distributors (mainly Mckesson, Cardinal and AmerisourceBergen). Forest develops drugs from both in-house research and licensing agreements with third parties. It then integrates these drugs into its marketing and distribution system. Forest pays particular attention to its R&D and sales efforts and has increased capital expenditures over the last year in order to increase it distribution, R&D and sales capacity. Most importantly, with many pharmaceutical companies experiencing dry pipelines in conjunction with drugs that are going off patent, FRX offers a great portfolio of branded drugs that have already been released.

Forest’s current portfolio of noteworthy drugs include: Namenda, Lexapro, Celexa and Benicar with Cambral and Combunox both or which were just approved and are being released in early 2005.

Namenda is a drug approved for moderate to severe and more recently mild to moderate Alzheimer’s disease. Namenda should achieve sales of approximately $250 million as of the end of this fiscal year (March 31, 2005). That is impressive for its first year being released given that its comparable branded competitor product Aricept, took several years to achieve sales of that size. After speaking with doctors, it appears that Namenda treats a wider range of symptoms and is a better product for treating Alzheimers.

Lexapro and Celexa
Lexapro is a single isomer version of Celexa which just went generic (Lexapro is still patent protected). Lexapro and Celexa are used for the treatment of depression and Lexapro is also prescribed for generalized anxiety disorder. Given that Celexa has lost its patent, I expect sales of this drug to drop drastically, partly mitigated by FRX’s release of its own generic. More importantly, because Lexapro is a more effective product, more patients will increasingly use Lexapro instead of Celexa. Sales of these two products should be approximately $2.5 billion for the 2005 fiscal year (ended 3/31/2005).

Benicar is a drug that treats hypertension and is in the same class of drugs as Merck’s Cozaar and Novartis’ Diovan (all part of the angio-tension II blocker class). Each of these comparable dugs have sales of approximately $2-3 billion annually. Benicar was launched in mid-2002 and started achieving profitability in the second quarter of 2004 with sales for FRX of $12 million (the profits are shared with Sankyo Pharma due to a co-promote agreement). This is miniscule in comparison to its competitor products. After asking doctors why this drug has lagged the performance of its peers, they responded that FRX has not done a great job marketing the drug. They indicated that all three drugs are very comparable in terms of how effective they are, but Benicar, they maintained is not as well known due to weaker marketing and sales of the product. In the past year, FRX has increased its sales force by roughly 40% and is increasingly focusing on its penetration of its branded portfolio.

Cambral and Combunox
Cambral is a drug that treats alcoholic dependence and there are not comparable drugs that exist to get an idea of a potential market size. Combunox is a combination oxycodone/ibuprofen product developed for the management of moderate to sever acute pain. Both of these drugs have been approved and are being released in early 2005. I have not given FRX any credit for these drugs in my valuation.

FRX also has a couple of other drugs in Phase 1-3 studies, but I have not given them any credit for these drugs either.

FRX has no debt and a large cash balance of approximately $2 billion. They have announced and begun a share buyback program for 30 million shares which equates to roughly $1.3 billion at today’s share price. In addition, FRX has solid earnings quality as seen below. FRX takes home IN CASH what it reports as earnings (as shown by the following calculated direct cash flow statement):
Quarterly Data
03/01 03/02 03/03 03/04 06/04 09/04
Cash Revenues $1,181 $1,601 $2,170 $2,585 $817 $799
Cash COGS (370) (455) (610) (766) (148) (146)

Cash GP $811 $1,146 $1,560 $1,819 $669 $654

Cash SG&A (523) (526) (540) (782) (230) (250)
Cash Cap-Ex (31) (36) (80) (102) (23) (17)
Cash R&D (117) (149) (218) (242) (78) (77)
Cash Oper. Exp. ($671) ($711) ($838) ($1,125)($332) ($344)

Cash Op. Income $140 $435 $722 $694 $337 $310

Cash Inc. Taxes (29) (74) (122) (206) (67) (34)

Cash Net Income $112 $361 $600 $488 $270 $276

GAAP Net Income $215 $338 $622 $736 $230 $295

Cash as % of GAAP51.9% 106.7% 96.5% 66.3% 117.6% 93.5%

FRX is also very conservative in its estimations of doubtful accounts, cash discounts and inventory reserved. If you have done any calculations based on the above chart, you will see that FRX has an effective income tax rate of approximately 21%. This is expected to remain until 2010 and is the result of foreign income generated in lower taxed foreign jurisdictions – principally from manufacturing operations in Ireland (tax incentives expire in 2010).

My intrinsic value calculation is based on the “very reliable” discounted cash flow analysis. I use a discount rate of 12% and terminal growth rate of 5% and what I consider to be conservative sales and margin assumptions. In addition, FRX is trading near its 10-year historical Enterprise/EBIT multiple low of 11x and p/e low of 16.0x (although the p/e number is distorted due to the high cash levels FRX maintains). Many may consider this to be a “GARP” investment, which I would not necessarily disagree with. Whatever you want to call it, FRX offers huge upside potential with limited downside risk and thus I view it as a great investment opportunity. As Buffet has said, “growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.” FRX has solid ROC characteristics (averaging 25-30% over the past few years before netting out any excess cash) and thus invests free cash back into a business that guarantees profitable growth.



Improvement in sales force which FRX has been focusing on for the past year should help in marketing Benicar

As the cloud that is hanging over pharma stocks, due to the negative announcements concerning Vioxx and recently Celebrex, starts to clear, FRX will increasingly be recognized as a pharma company with great fundamentals and a solid portfolio of branded drugs

Continued buybacks due to FRX’s share repurchase program began in the last quarter (FRX has only purchased approximately 2 million shares out of a 30 million buyback program – more than 10% of shares outstanding)

Potential for Namenda to far surpass Aricept sales due to it being a more effective product that treats a wider range of Alzheimer symptoms
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