Warner Chilcott likely to mark time

The eye-catching performance of the Elan Pharmaceuticals share price over the past 12 months has naturally overshadowed the performance of other pharmaceutical stocks quoted on the Irish Stock Exchange. These include United Drug and Warner Chilcott (formerly Galen).

United Drug operates a pharmaceutical wholesale and distribution business along with a consumer, medical and scientific products division and a contract sales outsourcing business. The group has a leading position in the Republic and Northern Ireland wholesale markets.

The shares have performed very strongly over the past year and are up by more than 25 per cent since the beginning of 2004 as the company continues to benefit from positive trends in its main markets.

In contrast, the Warner Chilcott share price has underperformed, recently reflected in a decline of 11 per cent year-to-date. Warner Chilcott is a Northern Ireland based company that has now become a focused player in the US women's healthcare market. Over the past three years the company has spent $1.3 billion (€1.06 billion) on acquisitions which has given it a strong portfolio of products, together with a specialist sales force in the US female healthcare and dermatology markets.

At its recent results announcement the company reported third quarter revenues of $118.8 million and earnings per share (EPS) of 24.8 US cents. This was slightly ahead of analysts' forecasts and supports estimates of annual growth in the 15-20 per cent range for the full year.

A key threat to Warner Chilcott comes from generic competition due to the fact that approximately 50 per cent of its products carry no patent protection or market exclusivity. Furthermore, the remaining patent life of many of its patent protected products is relatively short with an average patent life of about 4.5 years.

Patent protection can be extended through the development of line extensions to existing products. Essentially this involves the development of new formulations of existing products and bringing such formulations through the regulatory process and eventually to the market.

Warner Chilcott has a substantial portfolio of line extensions that is well advanced and this should avert much of the generic threat to several of its major franchises. Therefore, a key to continued growth in revenues and earnings will be how successful the company is in bringing such line extensions to the market.

Warner Chilcott is valued in line with several of its peers and at the current price its shares trade on a price earnings ratio of 11.7 and a dividend yield of 0.5 per cent. When it comes to international comparisons, most analysts now prefer yardsticks that depend more heavily on underlying cash flows and the total value of the enterprise. Enterprise Value (EV) divided by Earnings before Interest, Tax, Depreciation and Amortisation (EBITDA) is a valuation metric that is now favoured in global sectors such as pharmaceuticals.

For 2004 the EV/EBITDA multiple for Warner Chilcott is 7.3 which is in line with its US peers. A particular positive feature is that the company generates very strong free cash flow of approximately $60 million per quarter from operations. Warner Chilcott has been using the financial flexibility afforded by such strong cashflow to repurchase some of its own stock. Post its recent results, the company has continued to repurchase its own shares. This should help to arrest the recent weakness in the share price and indicates management's confidence that at current prices the shares offer value.

There is a clear dichotomy in the company's weak share price compared with its track record of growing revenues and profits. This probably reflects the fact that investors require more time to assess whether the relatively recent acquisition led transformation of the company will generate shareholder value over the medium to long term.

It would seem that the positive impact of the growth in cash flow and profits is still being offset by the negative impact of a perception that the company has embarked on a high-risk business strategy. The key to success will be how effective Warner Chilcott is in developing line extensions to existing products, and on how aggressive competitors are in attacking existing products. The shares are likely to mark time until there is positive news regarding the generic threat and the commercialisation of these key product line extensions.