Cephalon Is Worth Considering

Feb.16.11 | About: Cephalon, Inc. (CEPH)
Lately, in the pharmaceutical industry, it seems that you just can’t win. The big pharma companies are being thrown under the bus because of patent expirations, diminished pipelines and lawsuits. On the horizon are the firms most likely to be considered the next big pharma with a pipeline of products but also facing patent expirations and lawsuits.
In the case of Cephalon (NASDAQ:CEPH), it couldn’t catch a break if it was handed to them. On Friday February 11, 2011, Barron’s came out with an analyst report (article here) that downgraded Cephalon from “Average” to “Below Average” with a price target of $54. Considering that Cephalon was already selling within 8.5% of the 52-week low at the time the article was published, we’re not sure if Caris & Co. meant to avoid giving a sell recommendation or not.
The problem with Cephalon, according to research firm Caris & Co., is that the late stage pipeline of products coming due may not boost revenue if sales of recently introduced Nuvigil are any indication. Combined with the fact that Provigil, which contributes 50% to Cephalon’s revenue stream, is due to face patent expiration in April of 2012, and we’ve got a recipe for disaster. Caris & Co also feels that the three pipeline drugs (Lupuzor, Cinquil and CEP-33237) hold no promise for either treatment or commercial value. Adding to the caustic mix of diminishing sales from existing products and sub par pipeline are two court cases (Fentora and Amrix) which are likely not to go Cephalon’s way.

Not to be outdone, on February 15, 2011, a Jefferies & Co. analyst downgraded Cephalon to “Underperform” from “Buy” (article here). With the current price of CEPH going for around $58, it was shocking that the Jefferies analyst didn’t indicate that the stock should be sold considering that he (Corey Davis) has a target price of $48 instead of the previous price of $77.
If Mr. Davis feels so confident that CEPH is really worth 17% less than the current price why would it merely “underperfom” one day when only the day before it was indicated to possibly rise by 32%. With a spread of 60% in his change of opinion, it becomes challenging to believe Mr. Davis isn’t parroting the downgrade given by Caris & Co. that had such a large impact on stock price on February 11th.

Although we know how hard it is for some research and investment firms to actually say sell, the timing of these calls couldn’t be more poorly selected. Even if the stock were to accomplish the $48 level, it is too little too late. Investors needed to know that at $72 (52-week high) the stock was overpriced. Telling us that things won’t go well now is a slap in the face to some who possibly bought the stock at much higher levels. Our sell recommendation of Cephalon at $71 in early March 2010, (article here) was only rivaled by our initial speculative observation at $57 in late August 2009, (article here).

Since Cephalon is so close to the low and the negativity is running so high, we decided to run some numbers to see what the worst case scenario could be if the company were to actually survive (by the way, we think it will.)

According to Value Line dated January 14, 2011, the book value for Cephalon in 2009 was $30.19. Prior to the recession that began in 2007, Cephalon had its lowest price-to-book (P/B) ratio at 2.66 back in 2003. At that time, Cephalon had a price-to-earnings (P/E) ratio of 23.

Currently, Cephalon is selling for 11 times earnings and if the stock price were to match the P/B of 2003 then CEPH would be selling for $80. If we assume that Cephalon can only accomplish half of the $80 target, then the stock should rise to $69 or 19% above the current level.

On a cash flow basis, Value Line estimated the cash flow for 2010 to be $8.55 per share. Based on the average low price-to-cash flow (P/CF) over the last three years, the stock should be trading at $67.29. If considered on the lowest level of the high range in the P/CF over the last three years, CEPH would be selling for $72.85. The last 3 years are utterly the lowest on a relative basis making comparisons over this period the most conservative possible.

All of the scenarios indicated above assume that Cephalon doesn’t find a way to increase earnings going forward. Since the big name analysts are in agreement that this company is dead on arrival, we feel this company is worth a balanced second opinion. If for some reason the analysts are right about this company, then the downside target or downside risk is that the stock would fall to $51.63. However, considering the speculative nature of this selection (as with all Nasdaq 100 stocks) we prefer that CEPH occupy only a small portion of the portfolio while accepting at least 50% losses.

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