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To create the following list, we screened for drug makers with strong profitability that are undervalued by free cash flow.

We began with a universe of drug maker stocks that have reported rising gross profit margins over the past four years. Gross profit margin measures a company's financial health and is the profit that remains after deducting "cost of goods sold", which includes inventory. Companies with higher gross margins are considered more profitable and have a greater control of their costs.

We then looked for stocks appearing undervalued relative to their cash flows, indicated by high ratios of levered free cash flow/enterprise value.

Levered free cash flow is the amount of cash that remains after deducting interest payments on outstanding debt. Enterprise value is the sum of the firm's value from all ownership sources: market cap, outstanding debt, and preferred shares. When companies have ratios of levered free cash flow/enterprise value in excess of 10%, it may indicate that the company as a whole is being undervalued.

The List

For an interactive version of this chart, click on the image below. Average analyst recommendation sourced from Zacks Investment Research.

Do you think these stocks will continue to increase their profit margins? Use this list as a starting point for your own analysis.

1. SciClone Pharmaceuticals, Inc. (NASDAQ:SCLN): Engages in the development and commercialization of novel therapeutics for the treatment of oncology, infectious diseases, cardiovascular, urological, respiratory, and central nervous system disorders in the People's Republic of China and internationally.

  • Market cap at $256.01M, most recent closing price at $4.74.
  • Gross profit margins increased from 83.48% to 85.09% during the first time interval (12 months ending 2010-12-31 vs. 12 months ending 2009-12-31). For the second time interval, gross margins increased from 85.09% to 85.37% (12 months ending 2011-12-31 vs. 12 months ending 2010-12-31). And for the final time interval, gross margins increased from 85.37% to 85.92% (12 months ending 2012-12-31 vs. 12 months ending 2011-12-31).
  • Levered free cash flow at $33.22M vs. enterprise value at $171.60M (implies a LFCF/EV ratio at 19.36%).

By the end of fiscal fourth quarter 2012, SciClone's revenue dropped by 15.47% to $33.1 million compared to the same quarter last year. The company ran into some challenges clearing inventory due to unexpected buildup of hepatitis medication. Zadaxin as a result of issues related to its Novamed acquisition. However, CEO Dr. Freidhelm Bobel stated in the most recent earnings call that the company expects the issue to be resolved by the end of this current quarter. He also mentioned SciClone's extension of its promotion agreement with pharmaceutical company Sanofi through the end of 2013. This is good news for the company because sales have increased significantly under the agreement.

Investors should also note that Deloitte expects China's pharmaceutical market to reach $220 billion by 2020, making it second only to the United States' market. SciClone has a strong presence in China and it has several products undergoing approval there, including Loramyc. The tablet is used to treat oropharyngeal candidiasis, a common oral symptom of HIV. China has seen a rise in H.I.V. infections, with The New York Times reporting a 13% increase in new infections between January and October 2012 versus the same period in 2011.

2. Warner Chilcott plc (NASDAQ:WCRX): Focuses on the development, manufacture, and promotion of branded pharmaceutical products in women's healthcare, gastroenterology, dermatology, and urology segments in North America and western Europe markets.

  • Market cap at $3.76B, most recent closing price at $15.0.
  • Gross profit margins increased from 74.13% to 77.69% during the first time interval (12 months ending 2010-12-31 vs. 12 months ending 2009-12-31). For the second time interval, gross margins increased from 77.69% to 83.62% (12 months ending 2011-12-31 vs. 12 months ending 2010-12-31). And for the final time interval, gross margins increased from 83.62% to 85.16% (12 months ending 2012-12-31 vs. 12 months ending 2011-12-31).
  • Levered free cash flow at $822.25M vs. enterprise value at $7.16B (implies a LFCF/EV ratio at 11.48%).

Times are tough for drug makers due to loss of patent protection for blockbuster drugs. While Warner Chilcott reported a 38% rise in fourth-quarter profit in February, the company's revenue fell by 5.3% thanks to a 42% drop in sales of osteoporosis drug Actonel. The leading drug lost its exclusivity in Europe back in 2010, and PharmaTimes reports sales have since suffered from a combination of increased generic competition in Western Europe and Canada as well as a decline in the U.S. market.

Though the pharmaceutical company expects Actonel's continued declining sales to offset the growth of other promoted drugs, recent developments on the drug approval front have positioned the company for a better 2013 than previously expected. The FDA has approved three Warner Chilcott drugs within the last month: 220mg strength Doryx, oral contraceptive Minastrin 24 FE, and a to-be-named oral contraceptive. Both Doryx and the to-be-named oral contraceptive will launch later this year, in July and August, respectively. The 200 mg Doryx is a delayed release version of the company's acne drug and, as Zacks reports, has the potential to revive the line's declining sales.

Accounting data sourced from Google Finance. Levered free cash flow data sourced from Yahoo! Finance. Profitability data sourced from Fidelity. All other data sourced from Finviz.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: Business relationship disclosure: Kapitall is a team of analysts. This article was written by Mary-Lynn Cesar, one of our writers. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.

Source: Income Idea: 2 Undervalued Drug Makers With Rising Gross Profit Margins