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Mathematically speaking, free cash flow is net income plus depreciation, minus the total of dividends, capital expenditures, required debt repayments, and any other scheduled cash outlays. It’s basically a measure of how much hard cash a company generated in a given period after paying for its regular business expenses and growth initiatives. It is a good gauge of how well management is performing for its shareholders.

Some investors prefer free cash flow over earnings because they believe that earnings, which are largely an accounting figure, can be manipulated more easily than hard cash. Also, in some cases, earnings get distorted unintentionally by accounting principles. Depreciation is an excellent example of the latter, since the measure inherently represents money that has already been spent and has little-to-no impact on a company’s cash flow, but often has a major impact on earnings.

Of course, free cash flow isn’t the only metric one should consider when evaluating an investment opportunity, but it can quickly weed out companies that simply don’t measure up. To help investors find companies that have a solid history of generating healthy amounts of free cash flow, Value Line produces a weekly screen that highlights this metric and appears in the Index section of every issue of The Value Line Investment Survey.

Labeled “Biggest ‘Free Flow’ Cash Generators”, the screen lists the top 100 companies of the roughly 1,700 in The Value Line Investment Survey based on free cash flow generation over a trailing five-year period. The long time frame is used to ensure that companies with solid histories of creating cash flow are brought to the fore, weeding out operators that experience a temporary boost to their cash flow generation because of short-term or one-time events.

For this screen, we chose to only consider companies in the drug industry (see list below). Of the nine drug companies that made the list of top cash generators in the Value Line universe, we have selected Actavis, Inc. (ACT) for this review.

Actavis, Inc.

Actavis (formerly Watson Pharmaceuticals) is engaged in the development, manufacturing, marketing, sale and distribution of generic and branded pharmaceutical products. Net revenues for the Global Brands segment were $441.0 million (or approximately 10% of its total) in 2011. Roughly 84% of total generic net revenue comes from the U.S. Some notable brand name drugs that Actavis makes generic equivalents for include Lipitor, Wellbutrin, Plan B, Nicorette, and Percocet.

At the end of October, 2012, Watson acquired Actavis for $5.6 billion, creating the third-largest generic drug company worldwide, with annual revenues expected to reach $8 billion in 2013. The combined entity now maintains operations in more than 60 countries, with top-10 positions in more than 33 markets including the United States, the United Kingdom, Canada, Australia, and Russia. On January 28, 2013, Watson began trading under the name Actavis, which management believes is a better fit from a marketing perspective.

At its recent investor day, the company painted a pretty picture for the future of the newly combined entity. For one, it will be launching its version of Pulmicort (treats asthma) in the second quarter of this year. It also shouldn’t have competition for generic Lidoderm (local anesthetic due out September, 2013) over the intermediate term.

Actavis’ version of Adderall XR is not expected to have new competition this year. Currently, the only other maker of “generic” Adderall XR is Teva Pharmaceuticals (TEVA). That company’s product is actually an "authorized" generic because it is manufactured with brand-name Adderall XR by its developer, Shire PLC (SHPG), and then repackaged and relabeled by Teva. Actavis manufactures its version in-house, providing the company with the ability to undercut competing prices and better control raw material costs.

Actavis will have to wait five months until it is legally allowed to produce a generic version of CONCERTA (a.k.a. Ritalin). That’s because rival Covidien (COV) recently announced that it got approval from the U.S. Food and Drug Administration to exclusively manufacture and market a generic version after being “first-to-file” an Abbreviated New Drug Application (ANDA). According to “Paragraph IV” of the Federal Food, Drug, and Cosmetic Act, a company that proves a branded drug patent to be invalid, or demonstrates that a generic equivalent would not cannibalize branded volumes, is entitled to exclusively sell a generic version for 180 days. Actavis, and one other generic maker, should start selling their versions of the narcolepsy and attention-deficit hyperactivity disorder drug soon after the restriction is lifted in June. Actavis says Paragraph IV challenges will be a principal part of its North American growth strategy, along with new dosage forms.

Although competition will surely play a part in Actavis' bottom-line growth in 2013, we think merger execution will also have a significant impact. Progress has already been made on merging the businesses, but there is still plenty of opportunity to maximize cost synergies through “globalization of the business” (i.e., eliminating redundant jobs and consolidating facilities, equipment, and R&D resources).

Looking further out, the company restated its goal of double-digit earnings-per-share growth through 2016. Acquisitions are expected to remain a big part of its strategy, which ought to be supported by its above-average free cash flow. The company is also committed to an accelerated debt repayment plan and lowering its tax rate.

We think these shares offer compelling investment potential and suggest subscribers also read our full page report in The Value Line Investment Survey.

 

Company Name  Ticker
Actavis, Inc. ACT
Allergan, Inc. AGN
Biogen Idec Inc. BIIB
Celgene Corp. CELG
Endo Health Solns. ENDP
Forest Labs. FRX
Gilead Sciences GILD
Hi-Tech Pharmacal HITK
Warner Chilcott plc WCRX
   

At the time of this article's writing, the author did not have positions in any of the companies mentioned.