Forest Laboratories (NYSE: FRX ) recently reduced earnings guidance for the year to a range of $0.65 to $0.80 from earlier estimates of $0.95 to $1.10 a share because its estimated sales of Lexapro, its anti-depression drug, were too high. Lexapro came off patent in March, and as of October any other company can make and sell a generic version of it. The stock has been consistently rated as an "A" or "B" candidate on The Motley Fool's earnings quality score database, but was down 3.5% for the day. This raises the question of whether it is time to dump the stock or hang on to it with the hope that one or more of the drugs in the company's pipeline will be successful, replacing the revenue lost from Lexapro.
To decide, we often look at trend data, and Forest's trends can be seen in the chart. Revenue moved south last quarter but is actually up year over year by about $175 million to $4.565 billion. However, revenue for this fiscal year ending March 2013 is only $3.36 billion. Forest's estimates for Lexapro sales were too aggressive by about $35 million, and so clearly, Lexapro's declining sales are not the only issue causing the lower guidance.
Inventory levels and accounts receivable have also moved down along with revenue, which is positive given that had inventory grown despite declining revenues, the company might have been forced to unload older product at a smaller profit and cash flow would be negatively affected. Improving cash flow is a bright spot in the face of lowered revenue prospects.
The second chart shows declining earnings per share and net income since October 2010, as well as Forest's attempts to prop up declining earnings by reducing outstanding shares, which is a low-quality source of earnings. The company has no long-term debt, so cash has been used to reduce this float. Forest's healthy 32% operating cash flow margin allows for this reduction; however, the company pays no dividend and even a token dividend payout would likely entice stockholders to stay put. The stock since January has moved up from $30.63 to its current level of $34.67, despite a relatively flat overall market. Forest has a trailing P/E of 9.7 but a forward P/E of 20.7, so analysts have the earnings decline baked into this cake. One more thing to think about for the future. Howard Solomon -- the chairman, CEO, and president -- is 84 years old.
To be fair, Forest Labs spent roughly $800 million in the last 12 months on research and development, and there appears to be several promising drugs in Stage 3 trials or advanced in the pipeline. Some press recently suggested Forest could be a takeover target, and well-known takeover specialist Carl Icahn has a 9.9% position in the company. If it were to occur, timing for such a takeover is unclear.
Instead of holding Forest Labs and waiting for a turnaround, or takeover, consider doing more research on other highly ranked health-care-sector stocks such as Humana (NYSE: HUM ) , Cardinal Health (NYSE: CAH ) , or Aetna (NYSE: AET ) . These stocks pay dividends and have considerably higher potential for capital gains.
As a health-care service provider, Aetna carries no inventory and shows improved earnings and cash flow margins, and has reduced shares outstanding while reducing long-term debt. Aetna pays a $0.70 dividend, yielding 1.70%.
Humana is another health-care service provider with improving revenue, cash flow, operating and profit margins as well as no inventory to drag on earnings. As with Aetna, shares have been repurchased over the past two years but without adding long-term debt. However, investors may want to wait until the Supreme Court's verdict on the Affordable Care Act before purchasing shares of either of these stocks.
Cardinal Health is a health-care-services company that provides pharmaceutical and medical products and services largely to hospitals, doctors, laboratories, and clinics, among other providers. Cardinal enjoys healthy demand for its products and services, as exemplified by above-average revenue gains year over year. Despite its extremely low gross margin (i.e., very high cost of goods sold) and operating cash flow margin, it has positive free cash flow averaging almost $300 million per quarter. The company holds a modest amount of long-term debt, but debt levels have not increased over the last two years. Like the others, cash has been used to take shares out of circulation. Cardinal pays an annual dividend of $0.95, yielding 2.2%.
As always, Foolish readers should always make their investment decisions based on earnings quality.
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