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Forest Seeds a Growth Plan

Robert Steyer

Forest Laboratories(FRX) is facing a mid-cap version of a Big Pharma headache as it seeks new drugs to replace those that will lose U.S. patent protection early in the next decade.

This year is pivotal because Forest has two products that now account for 80% of revenue. By the end of this month, or early June, Forest will unveil late-stage clinical trial results for two drugs: a treatment for fibromyalgia and a stroke-preventer, which has been genetically engineered from the saliva of a vampire bat.

By year-end, it expects to hear from the Food and Drug Administration about a blood-pressure drug licensed from Mylan Laboratories. Also by year-end, it should have the results of a mid-stage clinical trial for a schizophrenia drug. And Forest has more activity in mind.

"The most important focus today and over the next several years is to license, co-promote or acquire products or companies that collectively will ... more than replace earnings" from current drugs, Lawrence Olanoff, the company's president and chief operating officer, said at an April 24 meeting with analysts. "We have taken a fairly aggressive attitude."

Forest's sense of urgency is based on the fact that the antidepressant Lexapro provided $2.1 billion, or 61% of revenue, and the Alzheimer's drug Namenda accounted for $660 million, or 19%, for the fiscal year ended March 31.

"They're going to have to spend a lot of money to replace those two drugs," said Brian Laegeler, of the independent research firm Morningstar. Right now, experimental compounds "are not enough" to replace the big sellers, added Laegeler, who doesn't own shares and whose firm doesn't have a financial relationship with Forest.

Lexapro's U.S. patent expires in March 2012, while Namenda's expires in April 2010. Company executives expect to receive an extra three years of exclusivity for Namenda if the FDA approves a once-a-day version of the twice-a-day pill.

Three to six years might seem like a long time before a generic-drug attack, but given the uncertainties of clinical trials, patent law and regulatory standards, Forest must move quickly on many fronts. "More shots on goal" to provide "greater insurance" is the way Olanoff describes Forest's strategy.

Olanoff's comments sounded more aggressive than Forest's has been in the past to David Steinberg of Deutsche Bank Securities. "If correct, this signals a departure, as Forest has made just this one relatively small acquisition in the past decade," says Steinberg in an April 24 research report. He is referring to the recent $494 million purchase of the antibiotic-maker Cerexa.

But Cerexa won't provide any commercial products for three or four years, and Wall Street is mindful of past Forest setbacks in clinical trials for an antibiotic and an Alzheimer's drug, as well as in a regulatory review for another Alzheimer's drug.

Uncertainty about R&D is one big reason why Steinberg is neutral on the stock. He doesn't own shares, and his firm says it expects to seek or receive investment-banking related compensation.

Steinberg is one of 20 analysts who are neutral, according to Thomson Financial. Nine analysts have buy recommendations and six have sell ratings.

The bulls say Forest is well-managed, has a strong balance sheet and is acting prudently to cope with the Lexapro and Namenda patents expiring. The bears say, even under the best circumstances, revenue from new drugs won't offset the impact of generic competition on the big-sellers.

Some analysts fret that even before Lexapro loses its patent protection, generic copies of other antidepressants will stunt sales growth. Andrew Forman, of WR Hambrecht, recently warned clients about the "generic termites" gnawing away at Lexapro's sales.

Managed care firms, Forman says in an April 25 research report, will continue to encourage doctors and patients to use cheap copies of former brand-name drugs at the expense of Lexapro and other patent-protected antidepressants.

Forman, who has a sell rating, doubts Lexapro can achieve the 9% to 10% sales growth forecast by management. Generics now account for 49% of total antidepressant prescriptions in the U.S., up from 31% just 12 months ago, says Forman, citing data from IMS Health.

Meanwhile, the payoff from experimental compounds "is simply too far away to help," he says. Given the pressure on Lexapro and uncertainty over R&D, "the obvious strategic question [is] who will Forest buy and how much will it overpay?" Forman doesn't own shares. His firm is a market maker.

Another bearish view comes from Andrew Swanson of Citigroup, who also has a sell rating. "We continue to believe Forest's pipeline does not justify current valuation, while a hyper-competitive licensing environment limits Forest's ability to reasonably acquire new products," Swanson wrote in a late April report to clients.

The deluge of generic antidepressants, plus "limited market growth" in this category, "could certainly put the company's earnings at risk," said Swanson, who doesn't own shares and whose firm is a market maker.

A more favorable view of Forest, which has achieved success by licensing other companies' products, comes from Lehman Brothers' Richard Silver. A "strong near- [and] medium-[term] growth outlook remains very much intact," thanks to Lexapro and Namenda and to the blood-pressure drug Benicar, says Silver, who has an overweight rating on the stock. "Long-term earnings diversification remains a critical requirement over time."

Silver says Lexapro's outlook "remains strong," and he notes that Forest hasn't seen "any substantial changes" in Lexapro's status among major managed care companies in light of generic competition. He doesn't own shares, but Lehman says it does and seeks to do business with companies mentioned in research reports.