After presenting an overview of the generic drug industry last week, today we'll look at our first generic drug maker.

I combed through a dozen companies in the industry, first and foremost checking their free cash flow, product mix, drug pipeline, earnings growth, and balance sheet. Most companies I looked at, incidentally, have stocks that are near, or making, new 52-week highs (unlike most biotechs).

New highs turn some people away because they imagine that a stock trades in a range, while others see new highs as vindication that a business is doing well. Concurrent with underlying business success, I'm in the camp that believes new highs are a good sign rather than something to fear, although of course valuation needs to be scrutinized either way.

The generic drug company highlighted here today has substantial free cash flow and net income, years of operating history, worthy potential, and a strong balance sheet. It's a good place to start with the industry.

There are many smaller, younger generic drug makers with promise, but most lack free cash flow, and given the competition they face, I'd rather see more results before betting on them. (We'll list the firms and address a few next week, in case you're interested.)

Mylan Labs overview
Our first company is Mylan Labs (NYSE:MYL) of Pittsburgh, Pa. Mylan, which is four decades old, produces both generic and branded drugs, with generics accounting for almost 90% of sales. It manufactures approximately 120 generic drugs in more than 260 dosage strengths.

Mylan has a deep product line, extensive marketing know-how, and innovative lab skills. The company has supply, distribution, and marketing contracts for 73 drugs made by other pharmaceutical companies, and has developed several extended-release generic drugs. It's able to produce high-quality generic drugs partly due to its branded drug business. It discovers novel drugs under its wholly owned subsidiaries, Bertek Pharmaceuticals and Mylan Technologies. The development platform is focused on cardiovascular, neurology, and dermatology drugs.

Its approximately 24 branded medications include Avita cream and gel, Phenytek for seizure control, and Mentax, an antifungal cream. Branded drug revenue for the recent third quarter leapt 86% to $66 million on the strength of its existing drugs and the launch of a new product -- Amnesteem for severe acne, which quickly gained 29% market share.

Its generic drugs include Albuterol for asthma and more than 160 others with names you probably wouldn't recognize. Sales of generics totaled $254 million in the third quarter, down 3% from a year ago due to the loss of sales exclusivity on one drug -- a pitfall in the industry that we spoke of last week. Mylan's branded drugs can cushion such declines.

Strong financials
Over the last nine months, Mylan's generic drug sales gained 6% to $763 million, while branded sales soared 56% to $151 million. Total sales for the nine months ended Dec. 31 rose 11% to $915 million. Free cash flow over the nine-month period was $232 million, or 25% of revenue, while free cash flow for the trailing 12 months was $267 million.

The company has the strongest balance sheet of all those that I considered, partly on account of its age and also because of management's aversion to debt. As of Dec. 31, Mylan had $253 million in cash and equivalents, and $454 million in marketable securities. This contrasts with zero debt aside from $20 million in "long-term obligations."

At nearly $29 per share, it has an enterprise value of $5.1 billion, which puts it at 19 times trailing free cash flow and 17 times estimated free cash flow for the year ended March 31. While this isn't cheap, it is modestly below the average free cash flow multiple afforded to S&P 500 companies, and Mylan's growth is above average.

Its goal, which should be taken with a grain of salt, is to average 15% annual growth over the long term. It's an aggressive aim. Over the last five years, it averaged 16.6% annual growth. Fiscal year 2003 ends this month, though, and earnings for the year will be relatively flat, up just 4%. However, guidance given by the company calls for a rebound to 19% earnings growth in fiscal 2004.

Mylan expects up to $1.69 in earnings per share for fiscal 2004, up from $1.42 in the year ending next week. The stock trades at 20.4 times the March 2003 earnings estimate and 17 times the 12-month forward estimate. It's at 16 times the free cash flow guess for next year.

Reasonable, if full, valuation
There is little sense in hoping for relentlessly steady growth from a company with a business model that has generic drugs doing very well for a short period of time and then meeting competition. There is little sense in hoping that any company will experience steady growth year after year, for 20 years -- so we don't.

In running a discounted cash flow model on Mylan, I used the following free cash flow per-share growth assumptions. The estimates are sporadic (hoped to be "natural"), and they allow for a disappointing year (low single-digit growth) about once every five years.

      Est. Annual FCF Growth
     Yr.         Yr.   1 19.0%    11   5.0% 2 15.0%    12  16.0%  3 11.0%    13   9.0% 4 10.0%    14  11.0% 5  4.0%    15   9.0% 6 18.0%    16   5.0% 7 15.0%    17  16.0% 8 12.0%    18  15.0% 9 10.0%    19  10.0% 10  9.0%    20   9.0%        Terminal 10.0%

The model used an 11% discount rate (near the historic annual return of the S&P 500), and assumed a 10% terminal growth rate. Some may argue 10% is heady, while others might say that the drug industry and its leaders will growth at a faster clip, as in the past.

Finally, share count dilution was put at 0.5% per year for the first five years and at 0.2% the following years. Mylan is buying back its shares -- its share count this year is lower than last -- so our dilution numbers might be overstated.

With the data entered, the spreadsheet spit out an intrinsic value for the stock of $28.39 per share. It currently trades at $28.92. The model -- which is far from flawless -- argues that the downside here is minimal (assuming the cash flow growth pans out), but also argues that upside is a waiting game (and may not pay off enough).

From a valuation perspective, the stock starts to become much more interesting in the low $20s -- where it traded a mere quarter ago. I need to keep learning much more about the company, but I already like it enough to start watching it and considering a buying opportunity.

Two caveats
I'm only recently learning about the generic drug industry, although I've followed pharmaceuticals for years. Last week, a reader working in the industry sent some clarifying statements that I posted on the Fool on the Hill discussion board (membership or free 30-day trial required). The information may be helpful if you, too, are just learning. Additionally, Mylan is being sued by Merck (NYSE:MRK) for patent infringement on one drug. Such suits are common, but can be costly.

Mylan is a company to consider if you're interested in investing in the long-term promise of generic drug makers. It may be a good "foundation" investment given its history, size, success, and quality of earnings and free cash flow.

It also offers a friendly dividend reinvestment plan (Drip) for those interested in regularly buying the stock without commissions. By dollar-cost averaging, you could arguably start to invest now. For those lump-summing it, I'd personally hope for a lower share price.

Jeff Fischer doesn't own any stocks mentioned in this column. The Fool has a disclosure policy.