Saturday, January 23, 2010

Are Fans of Forest Labs Right?

Forest Labs (FRX) is among the stock picks in this weekend's Barron's. Staff writer Jay Palmer does an excellent job laying out the bull case for FRX shares in Forest Lab's Prescription for Success. An unappreciated pipeline plus a huge cash horde add up to a winning combination. He isn't the first to think so.

Forest Labs has been a Lonely Value favorite for exactly these reasons. My first Forest post (See the Forest for its Cash) appeared in June of 2009. At the time, the company had $3 billion in cash and securities (zero debt) against a $7.4 billion market value. Fully 40% of Forest's market value was in cash and marketable securities. In addition, FRX was churning out over $1 billion a year in free cash flow. It still does.

The intervening 7 months have seen a 20% gain in FRX shares - decent, but not spectacular.

The January 19th earnings release reveals $3.9 billion in cash and securities, an increase of $262 million in just 3 months and $900 million since June. The ability of Forest Labs to generate cash is amazing.

Cash and securities still represent over 40% of the company's $9 billion market value. This is (in part) why Barron's concludes:
(FRX) is strikingly cheap. It trades at less than 8.7 times estimated earnings for the current fiscal year, a 25% discount to the pharmaceutical sector. Exclude that $3.6 billion cash hoard , equal to $12 a share, and the multiple drops to 5.
The article's cash balance numbers are dated, but it doesn't change the obvious conclusion.

Barron's
explains that the pessimism implied by Forest Labs' valuation is explained by a host of expiring patents, most notably FRX's bestseller Lexapro in 2012 and Namenda in 2015. These 2 drugs represent 80% of Forest Labs current revenue.

Nonetheless, in their remaining years, Forest's 2 best sellers alone should earn enough cash to justify the current market value. Shareholders are essentially receiving an option on everything else for free. This includes the portfolio of existing drugs (the other 20% of FRX revenue) that live beyond 2015 and a growing pipeline of new compounds.

Forest Labs is currently priced as if it is going to accumulate cash through 2015 and then just liquidate. But management has inked numerous deals to build its product portfolio in the last year. Indeed, Forest is not a typical pharmaceutical firm. As Mr. Palmer explains:
Forest doesn't employ thousands of in-house research scientists to conduct the risky and expensive work of discovering new molecules that might work as new drugs. Instead, Forest lets smaller biotech and medical-research firms come up with the drug and do the initial testing; it then swoops in with an offer to buy, or more often license, the promising ones. Historically, Forest has focused on late-stage drugs, but recently moved to also buy earlier-stage compounds. While that approach is riskier, the company takes sensible precautions. It typically makes an upfront payment, with the rest contingent on the drug clearing clinical testing and regulatory hurdles.
As a shareholder, I have come to appreciate the value of this flexibility. Still, Forest Labs isn't getting any credit.

Forest is being penalized for its capital allocation or lack thereof. A victim of its own success, it is slowly becoming a glorified savings account. Ironically, it is a cash machine that's being buried under cash. The cash balance is so large that it's dwarfing all other corporate actions.

A first class problem to be sure... This may be why one Bruce "I Count Cash" Berkowitz made Forest Labs a top holding in the Fairholme Fund.

Nonetheless, Forest's cash situation is conservatism taken to the point of absurdity.

What are the company's plans for this capital?

The pipeline is being upgraded, yet excess cash still builds. In the most recent conference call, the balance sheet got barely a mention. CFO Frank Perier said:
Our cash and marketable securities balance on December 31 was approximately $3.9 billion, an increase of $262 million from last quarter. Of this, approximately $1.1 billion or 27% of our cash and marketable securities are domiciled domestically with the remainder maintained by our international subsidiaries.
Why focus investor attention on where the cash is located? Perhaps if they tell us its 73% overseas, we'll quit asking about it. It's inaccessible. Please leave us alone. One wonders if it wouldn't be worth repatriating some (or all) of it, paying the taxes, and repurchasing FRX at 5x free cash flow. Forest seems desperate for shareholders to ignore the cash.

If this valuation isn't compelling enough, what price would move Forest to action?

On the conference call, no analyst asked management about the "$4 billion question". It's the elephant in the room. And it gets $100 million larger every month. How long can management expect investors to ignore the biggest component of FRX's value?

Does anyone doubt that Forest has enough resources to implement its strategy?

Isn't it time for a balanced approach to buybacks, dividends, and "product development"?

Is the company prepared to make an acquisition when its own shares trade at 5x free cash flow, ex cash? What other possible reason could there be to pile cash to such heights?

Ask the company to comment and you'll get a boilerplate answer or no response at all. Investor relations: not so much. In our last exchange, I was told:
We have made significant achievements in adding to the product development portfolio beyond the current patents and will look at share repurchases and dividends at the appropriate time.
Gotta love it. If not now, then when?

How high do cash balances have to go?

How cheap do FRX shares have to get?

But despite all these problems, Chairman and CEO Howard Solomon has built a wonderful company. Carl Icahn seems to agree. He purchased a million shares in late 2009. Maybe he and Bruce can convince Solomon & Co to dig the company out from under its mountain of cash.

Another positive sign: In December, Mr. Solomon announced that he exercised stock options for 1,200,000 shares of Forest Labs and that he intended to hold the resulting shares. It could be a reaction to Icahn or a vote of confidence.

Perhaps something is about to change at Forest. If not, a number of well-known investors,
one weekly publication, and Lonely Value will get a lesson on value traps.


Disclosure: Author owns FRX shares.

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