Forest Labs Faces Patent Expirations

By Ryan C. Fuhrmann | January 18, 2009 AAA

Copyrights on musical compositions or novels typically last 50 to 70 years after the creator's death. It's a shame that this doesn't apply to drug firms, because Forest Labs (NYSE:FRX) is facing the unpleasant prospect of patent expiration for its two biggest-selling drugs - after which generic drugs can begin stealing market share and revenue.

Top Two Drugs Drew 90% Of Third-Quarter Sales
Forest has little hope of staving off either of these coming expirations to generic competition from the likes of Teva Pharmaceutical Industries (Nasdaq:TEVA) and Mylan (Nasdaq:MYL), which is scheduled for the depression treatment drug Lexapro in early 2012 and roughly a year later for Namenda, which is primarily used to treat Alzheimer's disease. This is unfortunate, as Lexapro accounted for 64%, or $585.5 million of total third-quarter net sales of $920 million, results of which were reported January 20. Namenda accounted for another 26% of sales, demonstrating the extent of the top-line hole Forest will have to dig itself out of in just a few short years. (For more on evaluating drug companies, check out Measuring The Medicine Makers.)

Can Pipeline Offset Upcoming Expiries?
Analyst opinions are mixed about whether Forest has a strong enough pipeline to offset the upcoming expiries. Bystolic, which is used to treat hypertension, was released on the market but posted Q3 sales of only $21 million, although Forest is readying new drug applications for additional usage such as treating congestive heart failure. Other products on the market, such as AeroBid, AeroChamber and Campral reported very small quarterly sales compared to Forest's two blockbuster drugs.

Management believes that its late-stage pipeline "could collectively represent several billion dollars of potential product sales in the long-term sufficient to replace the revenues lost to the patent expiries for Lexapro and Namenda combined". Of course, it also conceded that this scenario might not turn out to be quite so rosy. The company must keep the pedal to the metal in terms of its earlier-stage pipeline, continuing to work with partners in licensing drugs and potentially acquiring competitors, such as the January 2007 purchase of privately held biotech firm Cerexa. (Learn how to evaluate an acquisition in The Merger - What To Do When Companies Converge.)

Profit Potential Is Significant In Immediate Future
Forest could also turn into prey if a giant pharmaceutical firm such as Merck (NYSE:MRK) or Eli Lilly (NYSE:LLY) finds its pipeline prospects promising. Also appealing to potential suitors, Forest is sitting on approximately $2 billion in cash, no long-term debt and is churning out in excess of $1 billion in operating cash flow while Lexapro and Namenda remain patent-protected. In other words, profit potential is significant for the next couple of years as illustrated by the $188 million in Q3 net income, or 62 cents per share, or 19% of net sales.

Final Thoughts
Finally, Forest's valuation is low with a fiscal 2009 forward P/E multiple of just over 7 based on the $3.35-$3.45 earnings guidance that management provided when it released Q3 results. Uncertainty lurks when looking out past 2011, but a fair amount of downside is already priced into the shares. Plus, Forest can pull a number of levers to enhance shareholder value going forward, and unlike a large pharmaceutical company, a couple of successful drugs could have a significantly beneficial impact on sales and profits.

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