Biovail - A Value Trap?

I’ve got an idea today that could either be a great value or a value trap. This particular stock has a 3.2% dividend yield. Debt is 23% of total capital and is covered nearly ten times by operating income. Perhaps most compelling is its 18% free cash flow yield. That is, the free cash flow (operating cash flow minus capex) divided by the price is 18%. This means that if you bought the whole company in its current state, you’d be earnings 18% on your money each year. And in case that doesn't make you salivate, nearly 1/5 of its market value is in cash.

Biovail (BVF) is trading at its lowest P/E, price/sales, and price/cash flow multiples since 2001. Net profit margins have been volatile, so based on average net profit margins of the past five years I calculate the stock as trading (cash stripped out) at under 8 times earnings on expected revenues of $950 million for next year, which represents a 6% drop from this year. Based on the factors above, it looks like the stock could use some serious consideration.

But what is the market telling us about its future prospects? Using a discounted cash flow model and a high discount rate (due to its business risk), it appears the market is pricing Biovail as if owner earnings (earnings minus CapEx plus depreciation) are going to be cut in half in the near future. This is entirely possible, mind you, as its primary revenue generator, Wellbutrin, accounts for 38% of its sales and it may lose market exclusivity for that one sooner than expected. Yet the company does have other drugs in the pipeline that could replenish this $300 million shortfall within a reasonable amount of time.

Biovail takes successful existing drugs that have come off-patent and makes them better. These reformulations are provided 3 years of market exclusivity, so there is considerable operational risk here. The company continually needs to come up with new ideas in a cost effective manner to growth profitably. Results have been volatile – certainly not as predictable as a seller of razor blades.

This lack of predictability makes Biovail a risky holding if the time horizon is long-term. To buy Biovail is to believe that the company will innovate in the future as they have in the past – with more and more drugs. They’ll need an increasing number of products at least every 3 years to continually grow their revenue base. Certainly, they have no competitive advantage in each individual product beyond market exclusivity. Yet perhaps they have an advantage in oral drug delivery technologies they use in their reformulations.

In order to invest in Biovail, I would need a reasonably good understanding of how sustainable the advantages are, if any, in the technology that Biovail uses. To me, it doesn’t seem like controlled release, graded release, enhanced absorption, rapid absorption, taste masking and oral disintegration technologies would be that difficult to copy. If they are easy to copy, the company’s only strength is in its ability to take an old drug, improve it before everyone else and get it to market the quickest. In this case, it's hard to evaluate sustainability into the future.

On top of these considerations, the company is under investigation for insider trading, financial disclosure and reporting, as well as product marketing practices. Yet the numbers make Biovail one to keep an eye on.