Forest Laboratories (NYSE:FRX) is no doubt relieved to see a tumultuous August come to an end. First, CEO Howard Solomon was finally notified by the Department of Health and Human Services that he would not be targeted for exclusion from dealing with Medicare and Medicaid programs. (The possibility was raised after a $313 million settlement a year ago, in which Forest was accused of a variety of misleading and unethical sales practices.) Two weeks later, billionaire Carl Icahn (who owns over 9% of Forest stock) finally lost his proxy fight against the company; Icahn had been attempting to install 4 new directors, with the goal of reducing Forest's spending on new products. Amidst it all, market volatility moved the stock, which dropped over 10% before rebounding to close down 6.6% for the month.
With some of the dust settled, at Wednesday's close of $34.24, Forest seems to offer some gaudy value credentials. It has a trailing P/E of 8.3, 25% of market cap in cash, and no debt. It generated over two billion dollars in free cash in fiscal years 2009 and 2010 combined, slipping back to a still-acceptable $820 million in FY 2011 (almost 12% of enterprise value) before returning to a billion-dollar run rate in the first fiscal quarter (ending in June).
But Forest is no longer a value play. The most pressing issue is, of course, the so-called "patent cliff" facing the pharmaceutical industry at large. For Forest the cliff is Lexapro, the company's blockbuster anti-depressant which comes off patent in March 2012. Lexapro accounted for 53% of the company's sales in the most recent quarter, and will face generic competition soon after its expiration. (Ivax, a unit of generic maker Teva (NYSE:TEVA), has litigated the Lexapro patent for years, and is no doubt eagerly awaiting its demise). Forest, in its March earnings report, acknowledged the severity of the situation. Fiscal year 2012 was guided at $3.60-$3.70 per share, while fiscal year 2013 was guided for "not below" $1.20 per share. Analysts surveyed by Reuters expect, on average, $1.37 for the twelve months ending March 2013, a two-thirds drop from the most recent fiscal year.
In response, Forest seems to have changed its strategy. The company was traditionally known for foregoing the development process, buying late-stage drug candidates and using its excellent marketing abilities to create revenue. The February purchase of Clinical Data shows the shift. The $1.3 billion purchase (about $4.75 in cash per FRX share) brought aboard only one approved drug: Viibyrd, an antidepressant which the company expects will partially replace the revenue from Lexapro (per the most recent 10-Q). In addition, the acquisition added stage III candidate apadenoson, for the treatment of COPD, along with other early-stage drugs. The impact on near-term earnings is actually negative; the company expects the acquisition to decrease 2012 earnings by 55 to 65 cents per share and notes it "may" add to earnings by FY 2014. Viibyrd, in the second quarter, accounted for only $7.3 million in revenue as Forest begins its formal launch of the newly-approved drug.
All this is not to say that FRX is no longer a good stock, nor Forest a good company. The company is accelerating its stock buyback program, and it was clear that, with the expiration of Lexapro, a change in strategy was needed. But investors can no longer rely on the huge cash balance (which was, at times, over 50% of market cap in 2009-2010) and pure marketing muscle for returns. Forest must have significant success with Viibyrd and apadenoson to justify the $1.3 billion price tag for Clinical Data. In addition, existing products such as Namenda (for moderate Alzheimer's; the drug accounted for 29% of sales last quarter), Bystolic, and Savella must continue to grow. Long-term, the Clinical Data early-stage pipeline and additional acquisitions must replenish the company's product lines and coffers.
These are not the characteristics of a value stock. A year from now FRX will likely sport a forward P/E in the range of 25 to 30 and more of the cash balance will have been earmarked for acquisitions of additional drugs, or entire pipelines. (Given the yields of competitors Pfizer (NYSE:PFE), Bristol Myers Squibb (NYSE:BMY), and Abbott Laboratories (NYSE:ABT) -- all of which are over 3.6% -- one has to wonder why Forest refuses to directly distribute some of its $2.3 billion cash hoard directly to shareholders, if that cash is not intended to expand the company's product line.) Industry-savvy insiders can speculate on the future success -- or failure -- of the company's current portfolio. But value investors should understand that behind the glossy numbers, Forest Laboratories offers more risk than meets the eye.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: I owned FRX, and managed portfolios in which FRX was owned, for a period covering parts of 2009 and 2010.