Warner Chilcott: Should You Buy Joel Greenblatt's Latest Pick?

Zarr is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Searching for potential stock investments can be a daunting task. With so many stocks to choose from – more than 2,300 listed on the NYSE and around 2,800 on Nasdaq – how do you find good ideas?

One way, and the probably the most common way, is the use of stock screens. With information on publicly listed companies increasingly available online, it is easier now to come up with a list of companies that meet a specific criteria.

However, there are still many things that mechanical screens miss, and with so many combinations of metrics possible, the use of stock screeners can be a bit overwhelming.

You could always follow Warren Buffett’s advice and start from "A." But if you are pressed for time, there is another excellent way to find potential ideas: looking into the portfolios of successful investors.

In this article series, I’ll be assessing the latest stock picks of Joel Greenblatt, creator of the "Magic Formula" screen and best-selling author of The Little Book That Beats the Market and You Can Be a Stock Market Genius. 

His hedge fund, Gotham Capital, has delivered annualized gains of more than 50% from 1985 to 1994. He recommends looking into special situations such as mergers, spinoffs, bankruptcy and restructuring, to find the best value opportunities.

As of the latest quarter, Joel Greenblatt bought 1,366,561 shares of Warner Chilcott (NASDAQ: WCRX) at an average price of $13.63, equivalent to 0.94% of his portfolio.

Business profile

Warner Chilcott is a mid-sized specialty pharmaceutical company that focuses on women’s health, dermatology, gastroenterology, and urology segments of the US and Western European markets. The company’s strategy is to focus on therapeutic areas dominated by specialists and other high-prescribing physicians.

<table> <tbody> <tr> <td><strong>COMPANY SNAPSHOT</strong></td> <td><strong> </strong></td> <td><strong>RATIOS</strong></td> <td><strong>WCRX</strong></td> <td><strong>SECTOR</strong></td> <td><strong>S&P</strong></td> </tr> <tr> <td>Price</td> <td>$19</td> <td>P/E</td> <td>12</td> <td>53</td> <td>17</td> </tr> <tr> <td>52-wk range</td> <td>$11-$21</td> <td>EV/EBITDA</td> <td>7</td> <td>11</td> <td>10</td> </tr> <tr> <td>Market cap</td> <td>$4.9 billion</td> <td>P/CF</td> <td>6</td> <td>15</td> <td>10</td> </tr> <tr> <td>Dividend yield</td> <td>2.6%</td> <td>P/S</td> <td>2</td> <td>3</td> <td>2</td> </tr> </tbody> </table>

<table> <tbody> <tr> <td><strong>FINANCIALS</strong></td> <td><strong>2012</strong></td> <td><strong>GROWTH RATE (ANNUAL)</strong></td> <td><strong>12-MONTH</strong></td> <td><strong>5-YEAR</strong></td> </tr> <tr> <td>Revenue</td> <td>$2.5 billion</td> <td>Revenue</td> <td>(6.7%)</td> <td>30%</td> </tr> <tr> <td>Operating Margin</td> <td>29%</td> <td>EBITDA</td> <td>6.4%</td> <td>37%</td> </tr> <tr> <td>Net Margin</td> <td>16%</td> <td>FCF</td> <td>(30.4%)</td> <td>40%</td> </tr> </tbody> </table>

Sources: morningstar.com, infinancials.com, gurufocus.com


The company has had an impressive run the past five years, growing revenues by 30% per year, EBITDA by 37% per year and free cash flow by 40% per year. It expanded operating and net margins to around 16% and 30%, respectively. It also converted an average of 30% of its sales into free cash flow.

With robust free cash flows, company shareholders have been greatly rewarded the last few years, receiving a special dividend of $8.50 per share in 2010, followed by a special dividend of $4 per share in Sept. 2012 and a recurring $0.50 annual dividend started in 2012.

Also, the company's several products have market-leading positions: Actonel is the leading branded product in the US oral biphosphate market for the prevention and treatment of osteoporosis; while Asacol is the leading treatment for ulcerative colitis in the US. 

Furthermore, the shares are trading at cheap valuations with EBIT/EV yield of 9%, EV/EBITDA of 7, and a P/CF of 6.


Several of the company's major products face patent expiration in the next few years. Actonel, which accounted for 12% of revenue in 2012, already lost patent protection in Canada in early 2010 and Western Europe in late 2010, and it also has seen its sales drop 28% in 2012 compared to the previous year. Also, Asacol, which accounted for 19% of revenue last year, will lose patent protection in the US in July of this year. Lastly, Loestrin 24 Fe, which accounted for 9% of revenue last year, will lose patent protection in the US in July 2014. 

On top of this, the company does not seem to have new products in the pipeline to offset the revenue it will lose from products coming off patent protection. This is due to the company's R&D strategy, which focuses on product life-cycle management -- making improvements to existing key products -- instead of developing new treatments. While this strategy has been highly profitable, it looks problematic in the long run.

In fact, much of the company's growth was generated from the sales of Actonel and Asacol, which was obtained from the acquisition of Procter & Gamble's branded pharmaceutical business in 2009.

Moreover, the company took on $600 million of additional debt last year to pay the special dividend of $1 billion -- a move that was seemingly taken to satisfy the company's three largest private equity holders, who at that time had 30% ownership of the company. This increased the company's debt to around $4 billion, limiting its opportunities for future acquisitions.

Warner Chilcott is worth more to Actavis

Actavis (NYSE: ACT), the third-largest generic drug company in the world, also had been the subject of takeover speculation for the last few months. In April, Valeant Pharmaceuticals (NYSE: VRX), the largest pharmaceutical company in Canada, with a market value of $29 billion, specializing in neurology, dermatology, and infectious diseases, offered to buy the company for more than $13 billion in stock. Mylan (NASDAQ: MYL), a rival global and generic specialty pharmaceutical manufacturer, on May 7, offered $120 in cash and stock, equivalent to around $15 billion, to buyout the company. It reached a definitive agreement with Warner Chilcott on May 20, 2013, to acquire the company by year-end in a stock-for-stock transaction valued at around $8.5 billion.

Under the agreement, Warner Chilcott shareholders will receive 0.16 shares of the newly created company "New Actavis" for each Warner Chilcott share they own. Based on the latest Actavis' closing price of $122 as of June 6, 2013, this equates to $19.50 per Warner Chilcott share.

The merger is expected to strengthen its non-generic drug segment in women's health and urology, generate more than $400 million in after-tax operational synergies, tax savings and cost reductions. It will also strengthen its balance sheet, bringing the ratio of debt/EBITDA closer to 3 and will be 30% accretive to Actavis' non-GAAP earnings per share in 2014.

Foolish bottom line 

Although Warner Chilcott generates healthy free cash flows and is trading at cheap valuations, its fundamentals are weak. It is worth more to Actavis than it is as a stand-alone company. I think it was already fairly priced at around $13 per share just before the merger news broke out.

As of the recent close on June 6, 2013, Warner Chilcott's stock price was at trading at $19 per share. At this price, I think there is little upside left and it would be too risky to initiate a position at these levels. However, I would consider buying if the stock price falls below $15 per share.

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Zarr Pacificador has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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