Giddy | Actavis: Free Cash Flows

Case study
Actavis: Free Cash Flows

Prof. Ian Giddy, New York University

Actavis
Based in Iceland, Actavis is one of the world's faster growing generic pharmaceutical companies. In mid 2006, the company made a bid for Croatia's leading generics company. The offer was half in cash, and half in shares. Management of the target company advised shareholders not to accept Actavis' bid, which was made in shares. Actavis, they argued, was overvalued and overleveraged, like the Icelandic market as a whole. They pointed to the fact that while the bidder's share price had risen 35% during the past year, earnings were flat.

Free Cash Flows
An investment advisor at HSBC urged her clients to look at Actavis differently. "When valuing a business, what counts is not earnings, but free cash flows. One should operating profits, i.e. earnings before interest and taxes. After adjusting for notional tax and depreciation, capital expenditures and the change in working capital, you'll see that Actavis' financials look a lot stronger."

Data (millions of ISK):
Revenue	11,000
Cost of Goods Sold	-3,000
Gross Profit	8,000
Depreciation	-700
SGA Costs	-1,000
EBIT	6,300
Interest	-1,000
Profit Before Tax	5,300
Taxation (30%)	1,590
Profit after Tax	3,710
Dividends	-500
Retained Earnings	3,210

Capital Expenditures	800
Change in Inventory	500
Change in Accts Receivable	1,200
Change in Accts Payable	750

Questions
1. Is she right? Using the data given above, please calculate Actavis' free cash flows to the firm (FCFF).
2. In the case of Actavis, what are the reasons free cash flows differ from earnings?