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Micro-Cap Magic Formula Stock — Forest Labs

July 15, 2011 | About:
Bloomberg TV

Paul Andrews

7 followers
What if you could buy into an industry leader in an industry almost guaranteed to grow at a rate faster than the general economy, but you could buy them at a discount to all of their peers?

What if the company not only traded for a discount to all of its peers and the market in general, but also had a history of both faster growth and much better returns on equity and capital? As an added bonus, what if the company had a fortress balance sheet that is already being used for ultra accretive share buybacks and an activist shareholder pushing for the company to “realize shareholder value” (aka sell themselves for a huge premium)?

Well, then you’d have the beginnings of a perfect stock. A stock we’d consider for GuruFocus’ own Micro-Cap Magic Formula Newsletter (btw, our next issue comes out tomorrow, and this month’s pick trades at a serious discount to peers possessing many of these characteristics).

So what is this stock?

Forest Labs (FRX). At its current price of $38.79, the company trades for ~10x earnings despite having no debt and over 20% of their market value in cash (note: Forest just completed an acquisition for ~$1.3 billion, or more than 10% of their market cap. Their most recent financial statements do not reflect this acquisition, but the 20% just mentioned is adjusted for it. If you were to just look at their balance sheet and not make the adjustment, well over 30% of their market cap would be in net cash). And it’s significantly overcapitalized balance sheet hasn’t prevented it from earning returns on assets over 16%... better than more than 90% of the S&P 500.

Why is it cheap?

So why is a company as good as Forest Labs selling for such rock bottom prices?

Simple.

In March 2012, Lexapro, a blockbuster drug for the treatment of major depressive disorder which accounted for 55% of their sales last year, will expire. After that, Lexapro will start facing generic competition and sales (and thus earnings) will likely come in materially lower in the future unless Forest can find a replacement product….And it’s highly unlikely Forest can find one product to replace Lexapro.

But that doesn’t mean Forest is going to be a terrible investment going forward. Far from it. Namenda, a treatment for Alzheimer’s, accounts for 30% of their sales, and is growing like gang-busters, and doesn’t come of patent until 2015. And Forest’s pipeline looks extremely strong, with several potential blockbusters in late stage development.

So will earnings come in lower in the future? Yes.

Does that mean Forest’s stock can’t go up? Absolutely not.

Catalyst

Forest’s strong pipeline and collection of patents could make them very appealing as an acquisition candidate.

Famed activist Carl Icahn (who we saw in last week’s stock) certainly seems to think so. He recently purchased 6.5% of the company and is aggravating for four board seats. We’ve seen this tactic from Icahn before at another pharama / bio-tech company, Genzyme (GENZ), and it ended with a sale of the company at a huge premium.

But shareholders could benefit even without FRX getting taken over. The company’s cash balance is much too big, and though the company just completed a $500 million accelerated share repurchase agreement in June, management could likely drive a lot of incremental value for shareholders simply by getting more aggressive with the use of their cash. Either another acquisition done at favorable prices or a much larger share repurchase would greatly benefit shareholders. Whatever they decide to do, you can be sure that Icahn’s presence will ensure it’s in his (and, by extension, shareholders) best interest.

To sum it all up, does Forest face some problems going forward? Sure, it’s never going to be easy losing the patent to an ultra-profitable blockbuster drug that accounts for over half of your revenue. But Forest has the wherewithal to easily weather that storm, and the long term looks pretty bright. Both management and Carl Icahn think the company is worth much more than the market currently thinks it is, and both of them are putting their money where their mouths are and buying large chunks of the stock.


Rating: 3.2/5 (13 votes)

Comments

positive_carry
Positive_carry - 2 years ago
How do you define "micro-cap"? Forest Labs is an $11B market cap company.

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