Institutional investors and sell-side analysts are rather infamous for gnat-like attention spans and the capacity to dramatically change their opinions in relatively short periods of time. So, too, has it been with Forest Labs (UNKNOWN:FRX.DL), though it certainly requires mentioning that Forest Labs has done a lot of work on its own to affect that change of opinion. Forest Labs announced a significant cost-cutting program and then followed it up with the nearly $3 billion purchase of Aptalis, both of which significantly impact the company's long term revenue and margin prospects.
I'm not totally sold on the company's "Project Rejuvenate", nor do I believe that all of the company's "Next Nine" products will live up to management's hopes. With that, I'm a little concerned that investor enthusiasm for the restructuring program at Forest Labs is getting caught up with excitement over similar programs at AstraZeneca, Valeant (NYSE:BHC), Endo, and Amgen -- and perhaps overdoing things.
Strong Sales Underpin Fiscal Q3 Results
All of the charges and adjustments in this quarter and the year-ago's make it difficult to say a lot about Forest Labs' basic profitably, but the company definitely did alright on the top line. Revenue rose 23% this quarter, handily beating the average estimate by more than 6%. Namenda sales led the way, growing 16% this quarter and beating expectations by almost 6% despite the maturity of this platform. Forest's other major product, Bystolic, saw sales rise another 20%.
Within the "Next Nine", Linzess (which the company sells in partnership with Ironwood (NASDAQ:IRWD) did quite well, as sales of about $51 million were 14% higher than expected. Fetzima and Teflaro also outperformed expectations by a double-digit percentage (contributing $8 million and $22 million, respectively), while Viibryrd's 28% growth and $52 million in revenue was more or less on plan. All told, the Next Nine were 44% of total sales.
Margin comparisons are comprehensively fouled by charges and adjustments, but underlying gross margin did improve more than a half-point from last year and was a little better than expected.
Aptalis Should Be A Winner
There was ample chatter out there that Aptalis was being aggressively shopped, and Forest Labs ultimately signed on the dotted line for $2.9 billion in cash – a not-so-cheap premium of 4.2x sales and a little more than nine times EBITDA. Aptalis is a GI-focused specialty pharmaceutical company with more than 60% of revenue coming from Zenpep, Carafate, and Canasa – three drugs that appear to have meaningful barriers to generic competition.
Aptalis is not only going to contribute some worthwhile drugs to Forest Labs, but it should also improve the company's efforts to establish a specialty presence in the GI treatment space. Linzess is still relatively new (launching late in 2012) and Forest Labs has to share a considerable percentage of its proceeds with Ironwood, but adding Aptalis's drugs gives the company the opportunity to drive more revenue from that existing Linzess sales force.
Restructuring Still Offers Some Risk
I'm not as sold on the company's "Project Rejuvenate" at this point. CEO Brent Saunders is looking to cut $500 million in annual expenses by FY 2016, with more than half of that coming out of the company's R&D budget and additional cuts and headcount reductions in marketing and administration.
Cutting down the sales spending could be tricky. Looking over IMS data, Forest Labs gets a sizable percentage of its revenue, around 70% or so, from primary care physicians (most of Big Pharma is in the 60%+ area), whereas companies like Valeant, Salix Pharmaceuticals, and Amgen get about a third or less of their sales from this generalist category. That could make shifting toward a more specialty-oriented sales force more challenging, particularly as the company tries to push a "hard switch" of patients over to Namenda XR.
I'm also not sold on the cut-down in R&D spending. Forest Labs has a long and uncommonly good track record of licensing early stage compounds and developing them through to approval, but this cut suggests to me that acquiring finished products (like the deal for Aptalis and the acquisition of Saphris from Merck) is going to be a bigger part of the growth plan. Management says that M&A is not its primary strategy for growth, but I don't know how to reconcile that with cutting down what has historically been an unusually good R&D effort.
The Bottom Line
I would not be surprised if Forest Labs did at least one more deal with the aim of reducing its tax rate to a level more comparable with Valeant. These tax inversion deals are certainly popular right now and it looks as though some investors are already starting to factor this in to long-term projections.
I come away thinking that the Street has gone a little overboard with its enthusiasm for these pharmaceutical makeovers, Forest Labs included. I can get on board with projections for long-term revenue growth in the high single digits and free cash flow margins in the high 20%'s, but it's hard for me to get to a fair value above the mid-$60's. A tax inversion deal would certainly boost my projected fair value, but I think there are still execution risks here with the cost cutting and the sales growth expectations for new products, and I'm inclined to stay on the sidelines for now.