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A Missed Opportunity

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This article is part of our Rising Star Portfolios series.

Sometimes you just have to watch it happen without you.

Near the end of March, I ran a screen I had developed to try to find companies that might make good candidates for my Messed-Up Expectations portfolio. In that port, I'm looking for companies at prices reflecting growth expectations that are lower than what they're likely capable of, and getting high returns when the market corrects its mistake.

Among others, the biotech company Cephalon (Nasdaq: CEPH  ) showed up. It appeared that priced-in expectations were for shrinking free cash flow over the next 10 years before "improving" to no growth at all from then on (discounting at my 15% hurdle rate). Somewhat intriguing, so I put it on a list of ones to look at further.

Before I could, though, Cephalon's share price jumped 34% to over $75 a week later when Valeant Pharmaceuticals (NYSE: VRX  ) began a hostile bid at $73 per share, valuing the company at $5.7 billion. Cephalon called the offer too low and rejected it. Now the two companies are locked in a battle over who will control the board of directors, as Valeant has nominated its own slate using a consent solicitation process.

Assuming the SEC approves the solicitation letting it move forward, and Cephalon's shareholders give the nod to Valeant, then Valeant has plans. The company said it would move to remove a poison pill provision currently in effect at Cephalon (a measure designed to make takeovers more difficult) and look at Cephalon's books. That might or might not lead to a higher offer.

It's going to be a hard fought battle, though. Cephalon has begun to urge its shareholders to reject the consent solicitation, saying that the current board is most familiar with the company and best suited to maximize shareholder value, as well as saying any board nominated by Valeant runs the risk of being biased in favor of Valeant.

Given what's happened, I have to ask myself, "Would I have chosen to invest in Cephalon?" The answer is, "Probably not."

Cephalon is facing the same patent cliff many other drugmakers are. In this case, Provigil, a sleep disorder drug that made up about 40% of Cephalon's revenue last year, loses patent protection next year. Valeant seems to believe that it can reduce costs enough to make the deal profitable, even after that expiration.

Other mid-size pharmaceutical companies are also facing patent expirations. For instance, Forest Laboratories (NYSE: FRX  ) loses protection on anti-depressant Lexapro next year and Alzheimer's drug Namenda in 2015. In its fiscal third quarter, Lexapro accounted for 55% of Forest's revenue, with Namenda contributing 30%.

Regardless of the risk of drastically reduced revenue in the not too-distant future -- something I'm not willing to take on in the MUE port -- the interest in Cephalon is causing speculation that others might be targets. If Valeant fails in its bid for Cephalon, Jazz Pharmaceuticals (Nasdaq: JAZZ  ) or Medicis Pharmaceutical (NYSE: MRX  ) might be next, according to one analyst. Their prices have moved up recently, thanks at least in part to such speculation.

All in all, I can't invest just on the hope that a company is going to be taken over. That's not a successful long-term strategy because I can't predict when such deals will be announced. So while I might wish that I had purchased shares before the announcement -- unlikely, given its dependence on Provigil -- I can live with having missed this one. There are plenty of other opportunities to look at.

To see what else is on my list of potential buys, visit my MUE discussion board.

This article is part of our Rising Star Portfolios series, where we give some of our most promising stock analysts cold, hard cash to manage on the Fool's behalf. We'd like you to track our performance and benefit from these real-money, real-time free stock picks. See all of our Rising Star analysts (and their portfolios).

Fool analyst Jim Mueller doesn't own shares of any company mentioned. He works for the Motley Fool Stock Advisor newsletter service. Motley Fool Alpha LLC owns shares of Medicis Pharmaceutical. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool's disclosure policy is never messed up.

Read/Post Comments (1) | Recommend This Article (3)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 11, 2011, at 7:32 PM, TrojanFan wrote:

    You should look at RIMM for your MUE portfolio.

    The reasons for the MUE are obvious. There is a widespread view that GOOG/AAPL will come to dominate the mobile computing sphere and that RIMM will be toast and go the way of PALM.

    I think that's an absurd overreaction and gives no credence to the firm's very valuable and difficult to replicate sales relationships with large enterprise buyers in the corporate and government realms.

    It is IT departments that are the purchase decision makers in that environment and the things that matter most to them (security, productivity, operating system speed and reliability) are not the same thing that matter to consumers (the "cool" factor, a broad spectrum of apps, stylish design).

    RIMM's balance sheet and efficiency ratios are stellar, too, by the way.

    The smartphone and tablet markets are more then large enough to support far more than a duopoly and even if RIMM is relegated to a number three player or worse and face a declining share of the market in future years, the rapid growth of the market itself will be more then adequate to compensate for that and drive revenue growth.

    All they have to do is survive to drive share price appreciation from a starting multiple this low.

    Now that's a pretty low bar to get over I'd have to say.

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Related Tickers

12/31/1969 7:00 PM
CEPH $0.00 Down +0.00 +0.00%
Cephalon, Inc. CAPS Rating: ****
FRX.DL $0.00 Down +0.00 +0.00%
Forest Laboratorie… CAPS Rating: ****
JAZZ $121.26 Down -0.35 -0.29%
Jazz Pharmaceutica… CAPS Rating: ****
MRX.DL $0.00 Down +0.00 +0.00%
Medicis Pharmaceut… CAPS Rating: No stars
VRX $21.96 Down -0.10 -0.45%
Valeant Pharmaceut… CAPS Rating: ***