Forest Labs & Wal-Mart

Forest Laboratories

FDA's advisory panel voted 10-5 against approving the drug, Daxas, and the share skidded by over 13%, closing at $28.25 for the week. FDA generally follows the panel's advice but is not bound to the panel's decision. The fate of Daxas, a once-a-week pill for chronic obstructive pulmonary disease, is key to Forest as it rebuilds its portfolio ahead of the Apr 2012 patent expiration of its top-selling drug, Lexapro, which contributes almost 60% to its revenue. Daxas is developed by Nycomed, a private Swiss company, but Forest holds the right to sell in the USA. Analysts' estimate for Daxas' peak sales of anything from $500m to $2.1b. Lexapro's sales is $2.3b.

Forest second top-seller is Namenda, which generates sales of $1.1b, with an annual growth rate of 15% recently. The drug patent is poised to expire in Apr 2015. In the last 2 years, 2 new drugs were launched - 1) Bystolic, launched in Jan 2008, recorded sales of $125.9m for the first 9 months of 2010 financial year, 2) Savella, launched Apr 2009, recorded sales of $15.4m in the recent 3rd quarter ended 31 Dec 2009.

Aside from the patent expiration challenge the company faces, the numbers look pretty decent:

1) Market cap - 305m shares x $28.25 = $8.6b

2) Cash & equivalents - $3.874b

3) Net profit - $0.768b

4) Free cash flow - $1b

Excluding cash & equivalent, the company is valued at 4.7 times FCF or 6 times earnings - less than half of Pfizer valuation, which its top-seller, Lipitor, with $12b in sales is expiring.

Wal-Mart Stores

Based on forward PE, WMT is selling at a slight discount to other fellow retailers. WMT is estimated to earn $3.98 a share, and at $55, PE is 13.8. Target, TJX, Family Dollar, Costco Warehouse, BJ Warehouse, are selling at PE of about 15, with Costco the highest at over 20.

Thomson Reuters reported same-store sales - an important metric that compares sales for stores that are open at least a year - for the month of March 2010 hit a record high of 9.1% for retailers. TJX posted 12% growth, BJ Warehouse up 10.6%, Target up 10.3%, Costco up 10%, and Family Dollar up 11%. Wal-Mart does not report monthly same-store sales.

Walmart share price had lagged most of her fellow retailers the past year, though it is up 10%.

Basic information on DJIA

Total earnings for calender year 2008/9 = $253.5b

Total earnings for calender year 2009//10 = $205b

Market cap/PE at 2009 low based on 2009/10 earnings = $2.175 trillion / PE 10.6

Market cap at 2009 high based on 2009/10

earnings = $3.774 trillion / PE 18.4

Market cap as at 02 March 2010 = $3.5 trillion / PE 17.1

Out of the 30 companies, 2 companies made a loss during 2009/10. Excluding these 2 companies, PE, as at 02 March 2010, would be 16.

More details as follow.

A look at Dean Foods

Over the past two days, DF stock price plunged almost 20% because its Q4 earnings came in below estimates, lower-than-expected earnings forecast and faces headwind on higher cost of dairy milk.

DF has an annual sales of about $11.1B. Of which $8B goes to cost of sales, $2.5B goes to operating expenses, and $0.25B goes to interest expense. Leaving about $0.35b to both stockowners and Uncle Sam - of which tax rate is 35%.

In 2009, DF earned $1.38 a share or $240m. With an outstanding share count of 183 million, the company is valued at $2.65b. Free cash flow for 09 was $391m.

Now DF looks cheap compared to many of her competitors, who easily are valued from 13 to 16 times its earnings or even higher based on FCF. This could be because DF is a low, if not the lowest, margin food business. DF is also highly leveraged at 5.77 times of shareholder's equity. To operate the whole business, $7.8 billion in total is needed. Of which, $4.2b is interest-bearing debt, $1.37b from shareowners, and the rest from trade debtors and others.

The question is the sustainability at such highly-levered rate. The cash flow certainly can service the interest payment and pay down debts. We know that all business are structured differently - some with more equity, and some with more debts - but in the end, all are financed through different sources which are different in seniority. Now, lets assume DF is debt-free, i.e, DF must convert the $4.2B into equity. Then the market value increase from $2.65b to$6.85b ($2.65B + $4.2B). Then, DF need not have to pay a dime of interest expense which will save them $250m a year, or $163m after-tax. In total, DF would earns $403m ($240m + $163m), which prices DF at a PE valuation of 17 ($6.85b / $403m).

I know the above seems confusing. In summary, stock holders put up $1.37b in equity to get a return of $240m after tax, while, debt-holders put up $4.2b to get a return of $250m before tax.

So a debt-less structure would be less advantageous to the current stockowners. Therefore, it would be better that DF structure the business where it is financed more by debts than by equity holders, where equity holders will get more of the share of the pie, and debt-holders less.

In conclusion, DF is relatively cheap, but not without reasons and risks. The main risk is DF must meet certain financial covenants on her financial debts. If DF fails to meet such covenants in the event of really adverse economic conditions, share price would plunge because the company may be forced to restructured the financing structure of the business by converting debt to equity at a price that is totally disadvantageous to current common shareowners. But at $14.5 - moreover at a 52-week low - it is worth to take a look. I wouldn't say this is a good long-term holding but certainly a holding that would get a reasonable return within a reasonable time frame.

I am also looking at the defence contractors sector - players like Raytheon, Northrop Grumman, Lockheed Martin, General Dynamics, L-3 Communications. Will share more on this when I am through.

10,000 Hours of Practice

Many investors are impressed by Warren Buffett's ability to make an investment decision in 5 minutes. In a recent town hall meeting at Columbia University, a student asked which particular information does Buffett looks at to make an investment decision in 5 minutes. Buffett answered: "Well, it is basically 50 years of preparation and 5 minutes of investment decision."

And his answer struck me and brought me back to a chapter that I read in the book Outliers by Malcolm Gladwell. In the book lies the ingredients for success. One of the ingredients is clocking 10,000 hours of practice just to attain a skill such that it functions as how your arms and legs do for you.

When we look at outliers like Bill Gates, Tiger Woods, or Roger Federer, it is so easy to assume they had it easy because they are cruising their way through competition and life. But the question is how did they get to where they are. All of them, in fact, devoted more than 10,000 hours of practice just to get the correct stroke, or basics, perfect. How many of us have the will and patience to do the same thing over and over again just to get a single subject perfect? And yet we envy them and think they had it easy, though it is undoubtable they have the innate talent for what they do. So even for the best in class need to put in tons of time and effort to get it right. How about the rest of us, the ordinary folks? All the more we should put in more time to get it right, even we can never get to the level of the outliers, but at least, we would end up in the top 10 or 20 percentile - to get an advantage over the others who don't devote time and effort who have the same innate capability.

Take for example, Berkshire's investment in the Coca Cola Co in 1988. Buffett has been a Cola drinker all his life - though he was a Pepsi drinker earlier in his life. He had been evaluating Coke all his life ever since he started buying 6-pack cans of coke and broke it up to sell for a dime each. For 50 years, he did not own a share of Coke - a period where he knows hell lots about what is tipping the advantage towards Coke's economic future. For instance, the advent of refrigeration caused a surge in Coke's sales volume in the 1960s. Beginning 1980s, with the opening up and growth of the Asian economies, Coke is bound to have a bigger share of the beverage market (international sales made up more than 50% of its operating profit today). It was only in 1988 that a sudden down shift in Coke's share price that Berkshire made a huge investment in Coke without much further evaluation because he knew all the factors that drove Coke's business and profit at the back of his hand with 50 years of knowledge. So that is basically the effect of "50 years of preparation and 5 minutes of investing decision."

Lack of patience is well evidenced when a young shareholder asked Charlie Munger how to follow in his footsteps to becoming rich. Munger responded: "We get these questions a lot from the enterprising young. It's a very intelligent question. You look at some old guy who's rich and you ask, 'How can I become like you, except faster?' Spend each day trying to be a little wiser than you were when you woke up. Discharge your duties faithfully and well. Step by step you get ahead, but not necessarily in fast spurts. But you build discipline by preparing for fast spurts. Slug it out one inch at a time, day by day, at the end of the day - if you live long enough - most people get what they deserve."

In short, success is about continuous learning even after you get it right. The more you know, the less time you need to make a decision because you would have known most, if not all of the unnecessary information you would have looked at when you started and eliminate those from the decision process. Again, Munger pointed out that 10% of freight carries 90% of the weight. So to get to the level of making a decision in 5 minutes, we need to know which are the 10% of the freight and to arrive there, we need patience, and continuous practice and learning. In Munger's terms, building a latticework of mental models. So when someone tells you a short cut, there's no short cut. If it sounds too easy and good, it is most likely too good to be true.