"If you go out in the woods today,
You'd better not go alone.
It's lovely out in the woods today,
But safer to stay at home. " Teddy Bear's Picnic, J.Kennedy
It's hard to find a healthcare stock where there is such a wide divergence of opinion and range of possible outcomes as with Forest Labs (FRX). Despite an exemplary record of free cash flow production and sales execution, many analysts still cannot find the will to believe that the company can reload after the loss of Lexapro and resume a growth trajectory. While there are in fact good reasons to wonder about the future growth of the company, this is a story where the courageous could come out with sizable capital gains.
Tough Q1 Results
Relative to a very broad range of expectations, Forest Labs did alright this quarter. Sales of Lexapro fell about 80% and actually held up slightly better than expected, though a generic version is available from Teva (TEVA) at a 65% price discount. Namenda sales rose 15% and came in more than 5% below expectation. Bystolic outperformed by a similar percentage, though, as sales rose 38%. The company's newer drugs (Savella, Daliresp, Viibryd) didn't offer too many surprises, though Viibryd was a little stronger than expected.
Profitability was a little iffier, but still more or less in line (though, again, there was a wide range of expectations). Gross margin improved slightly, while operating income plunged as the company continues to spend on SG&A and R&D.
Are Nine Dwarves Better Than Two Snow Whites?
Without a doubt, the biggest question hanging over Forest Labs is whether the company can replace the revenue of Lexapro and Namenda (which goes off patent starting in 2015). While an alternative formulation will preserve some Namenda revenue past 2015, the fact remains that the company has a huge hole to fill.
Instead of taking a big swing and looking to in-license a potential blockbuster, Forest Labs management has instead looked to build a much broader portfolio of drugs. The company has taken to calling these the "Next Nine", and the group includes already-marketed drugs like Bystolic, Viibryd, and Daliresp, along with pipeline candidates aclindinium, linaclotide, and cariprazine.
Unfortunately, the results so far have been mixed. Forest Labs has done a great job with Bystolic - turning what was supposed to be an "also-ran" blood pressure drug into one with more than $500 million in annual sales potential. Likewise, Viibryd seems to be exceeding initially low expectations. On the flip side, early results from Daliresp and Teflaro haven't been as encouraging.
Of the Next Nine, aclidinium and linaclotide ought to have the most potential. Similar to Spiriva, aclidinium could have sales potential over a half-billion dollars, but skeptics believe generics and competition from GlaxoSmithKline (GSK) and Theravance (THRX) (partnered together on Brevo) could result in sales of half that level. Likewise with linaclotide. The potential market for an effective drug for IBS with constipation should be quite large, but this indication has been a Bermuda Triangle for many companies and Forest could also face competition from Salix's (SLXP) Xifaxan.
The Rather Loud Elephant In The Room
It's all but impossible to talk about Forest Labs without mentioning the sizable stake and recent agitation from famous investor Carl Icahn. Icahn is trying to get four seats of Forest Labs' board, and suffice it to say that CEO Howard Solomon is not encouraging or cooperating with him.
There's a lot of hyperbole when it comes to Icahn, but one of his stated issues - the murky succession plans for CEO Solomon - is very much a legitimate concern. There's rampant speculation that he wishes to hand the reins over to his son Howard, and I can absolutely support the argument that there needs to be a more open discussion (or competition, if you will) throughout the process.
All of that said, Icahn's slate was roundly rejected last year. Moreover, it should be mentioned that Icahn was pushing Amylin Pharmaceuticals (AMLN) to accept a bid from Bristol-Myers (BMY) when the rumored price was just $22 a share; holding out a few months brought Amylin shareholders another $9 per share in value - value that they would have never seen had management blindly followed Icahn. In other words, Icahn is a smart man but he isn't always right.
The Bottom Line
With the large amount of cash on hand the fairly uninspiring sales outlook for much of the Next Nine (four of the nine would probably be lucky to hit $200 million in annual sales), it's a little surprising that the company hasn't been more aggressive in considering deals. AstraZeneca (AZN) and Amgen (AMGN) have both been more active of late, and they arguably don't have the same pressing need for revenue that Forest Labs has.
All of that said, I still believe estimates and confidence are too low here. Forest Labs has a very strong sales infrastructure the business has reliably converted revenue to free cash flow at a rate from the high teens to mid-20's. While I think that future free cash flow margin is likely to be lower, I still think these shares are worth something in the mid-$40s and could hold even more upside for patient (but very risk-tolerant) bulls.