Reiterating Hold Recommendation on Forest Labs

Forest Laboratories, Inc. (FRX) turned in a very solid fiscal 2008. While 3rd quarter revenue was below our forecast, EPS was significantly better due to stronger operating margins as a result of better-than-expected gross margins and lower R&D and SG&A expenses. Revenue came in about $11 million shy of our expectations due to lower than forecast sales of Lexapro. We expect Lexapro sales to show a modest improvement now with the adolescent indication added to the label.

Management's guidance for the full fiscal year remains below results in 2008, but has been revised upwards for the 3rd time. Forest now expects full-year adjusted EPS in the range of $3.35 - $3.45. The guidance reflects lower R&D expenses in the current quarter relative to previous expectations.

We expect higher SG&A expenses through the remainder of the year to support the continued roll-out of Bystolic (for hypertension) and the initial launch of Savella (for fibromyalgia).

We forecast revenue growth of 3.3% in 2009 and look for EPS to come in at $3.46. The shares are down about 39% following the early September release of the disappointing phase III aclidinium data. However, the recent reversal by the USPTO relative to the Bystolic patent and FDA approval of Savella should offer investors some relief. The stock currently trades at 6.3x our 2009 EPS forecast.

Concerns remain about the strength of the pipeline relative to the loss in sales that will come with the Lexapro and Namenda patent expirations. We model Lexapro to account for over 50% of total revenue in 2011. With the drug losing patent protection in March 2012, that means roughly half the company's top-line will be at risk to generic competition.

While Bystolic and Savella should be very meaningful contributors by that time, we expect their combined sales in 2012 to be only about 29% of Lexapro's at that time. Namenda will face generic competition by 2015, at the least ? this puts another $1+ billion at risk.

Forest has a number of other candidates in their pipeline that have the potential to be very big contributors ? but none likely to make a meaningful impact by the time Lexapro goes generic. Management's most recent goal is to double their current pipeline by 2012 ? a lofty goal in just three years time, although one that is necessary to fill the enormous hole that key drugs will leave beginning in 2012.

The recent disappointment with aclidinium makes this goal seem even more difficult to reach. We expect Forest will continue to look for additional licensing and partnering deals to help fill its pipeline gaps.

We expect 4-year revenue CAGR of 5.5% through the end of fiscal 2012 with EPS growing at 5.0% over the same period. We expect EPS to grow slightly slower than the top-line due to near-term heavy-spend on SG&A to support new product launches and on R&D in support of the pipeline.

We have a Hold recommendation on the shares of Forest Labs. We are concerned over the potential shortfall in revenue contribution of the company's late-stage pipeline relative to the exposure of Lexapro and Namenda to generic competition beginning in 2012.

However, given the relatively cheap valuation (6.3x 2009 EPS versus peer group of 12.1x) and the potential for Forest to beef up its pipeline with additional licensing deals, we think the shares remain attractive as a core holding. Our target is $25 per share.