Allergan Defends Its Territory Against Increased Competition

 Allergan  faces some considerable challenges over the next few years, but we believe its long-term potential is intact. Highly defensible markets combined with the compelling opportunities of its pipeline give us confidence that the firm can reach its growth and profitability potential, which justifies its wide Morningstar Economic Moat Rating, in our opinion.

Although Allergan faces increasing competition on some of its key products, this threat should have a limited impact, in our view. Botox, Allergan's largest product and foundation of the company's moat, will probably cede additional share in the facial wrinkle cosmetic market as new competitors emerge. As with previous neuromodulator launches in the cosmetic market (such as Valeant's (VRX) Dysport), we think Merz Pharmaceuticals' launch of Xeomin in 2013 will have a modest effect on Botox. Allergan's unmatched cosmetic product portfolio, patient familiarity, and physician loyalty incentive programs have made competitor inroads into market share slow. However, we view Johnson & Johnson's (JNJ) PurTox launch, likely near 2014 by our estimate, as a potential game changer. Thanks to J&J's existing product portfolio, extensive salesforce, and deep pockets, we think the cosmetic neuromodulator market will gradually shift toward a duopoly rather than the current near-monopoly.

Allergan should face branded competition on some of its other key products, like its Juvederm facial filler, but its portfolio of difficult-to-manufacture biologic and ophthalmology drugs should keep generic competition minimized. For instance, stringent regulatory approval criteria on Allergan's dry-eye drug Restasis, which makes up nearly 13% of sales, remove substantial risk of generic entrants. Allergan has a long record of avoiding generic competition by defending its patents and transitioning patients to new product formulations. Allergan's patents for Alphagan, its alpha-2 agonist for glaucoma, were upheld beyond 2020, and we think management has time to avoid most of its remaining patent exposure, such as Lumigan for glaucoma. Even when generic competition occurs, requirements for clinical trials on generic ocular drugs limit generic releases, which should help protect Allergan's profit margins.

We Like the Looks of the Product Pipeline
Much of Allergan's ultimate success depends on new product development, and we have a favorable outlook on the company's pipeline. Despite competitor pressure on cosmetic Botox sales, management continues to utilize new therapeutic indications for Botox to expand into new treatment categories where the company faces almost no competition for the time being. Along with recent Food and Drug Administration approvals for Botox to treat chronic migraines, adult upper limb spasticity, and urinary incontinence, management is adding complementary products, such as Levadex for chronic migraine and apaziquone for bladder cancer, to dovetail with the company's entry into the neurology and urology markets. Allergan has other new potential indications for Botox in its pipeline, including treatment for cerebral palsy (Phase III) and osteoarthritic pain (Phase II). Moreover, Allergan has developed senrebotase, a novel biologic molecule derived from Botox that only affects pain receptors, and has initiated two Phase II clinical trials for the drug in targeted pain and overactive bladder treatments. Allergan's expansion of the neuromodulator therapeutic market should preserve the company's dominance in this industry and overcome the competitive pressures it faces in the cosmetic neuromodulator market. These therapeutic sales, which currently constitute about half of total Botox sales, should maintain the company's total market share above 65%, in our view. Meanwhile, senrebotase has the potential to transform the neuromodulator market as management pursues other indications related to oncology and inflammation.

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Other pipeline products look attractive as well. In the ophthalmology market, we think Allergan's sustained release products for glaucoma, macular edema, and wet and dry age-related macular degeneration offer compelling growth opportunities and should ensure Allergan's leadership in the eye-care market. These products have the potential to diminish the use of conventional eye drops for treating glaucoma and minimize the frequency of injections for treating other retinal diseases like macular edema and AMD. The long-term efficacy of Allergan's licensed anti-VEGF DARPin, for example, has the potential to beat out Roche's (RHHBY) Lucentis and Regeneron/Bayer's (REGN)/(BAYRY) Eylea in the wet AMD market. In dermatology, Allergan has brow and scalp hair growth versions of its novel eyelash extender Latisse in Phase II clinical trials.

Botox Is the Backbone of Allergan's Moat
Allergan has dug a wide economic moat thanks to its defensible products with strong brand recognition and impressive ability to innovate. At nearly 30% of revenue, Botox forms the backbone of the company's moat. Neurotoxins like Botox require complex manufacturing processes, and as biological compounds, they also require expensive clinical trials in order to receive FDA approval. Additionally, since each injectable neurotoxin has unique characteristics and produces different effects, doctors and patients are hesitant to switch brands; this is a significant difference from generic competition on most drugs. To date, only two other neurotoxins have been approved for use in the United States. While Botox does face competition for its original approval, the cosmetic removal of facial wrinkles, management has expanded its market into numerous therapeutic categories where it essentially enjoys a monopoly. Current approved therapeutic indications include blepharospasm, strabismus, cervical dystonia, severe primary axillary hyperhidrosis, upper limb spasticity, chronic migraine, and urinary incontinence. High barriers to entry in the neurotoxin market have enabled management to defend Botox's market share, which stands near 75%.

The Botox brand also enabled management to build a difficult-to-replicate aesthetic product portfolio, including facial fillers, breast implants, obesity intervention devices, and other skin-care products. Allergan continues to expand the aesthetic market with Latisse, the world's first eyelash extender. Broad product scope and rebate programs for high-volume plastic surgeons keep brand loyalty high.

Lastly, most of Allergan's drugs, such as eye pharmaceuticals and skin ointments, face limited generic competition. Generic approval for these types of drugs requires small clinical trials to prove effectiveness, and the added cost and time to gain generic approval keeps heavy competition away. Management has successfully fended off most generic threats through patent litigation and new product launches, a trend we imagine it can preserve.

Pipeline Failure and Competition Are Biggest Risks
Pipeline failures and drug competition, both branded and generic, pose the greatest risk to Allergan's operations. Allergan's ophthalmology portfolio makes up nearly 50% of revenue, and generic competition for approximately half of its products in this category could be problematic during the next few years. Allergan's Alphagan for glaucoma and Acular for inflammation just recently faced generic competition, and other large franchises like Lumigan for glaucoma could face generic competition down the road. While Restasis for dry eye probably won't face generic competition, a potential competing branded product could slow Allergan's trajectory in this category. Additionally, J&J's development of PurTox should eventually bring a strong competitor into the cosmetic market, but the need for expensive clinical trials should protect much of Botox's therapeutic markets for the time being.

FDA approvals for line extensions and new drugs, such as Ozurdex for macular edema, five new ocular drugs currently in Phase II trials, and a novel neuromodulator molecule for pain management, should alleviate Allergan's patent expiration exposure. However, without sufficient follow-on drugs to replace its expiring products, pipeline failures would cause problems for Allergan.

The company's recent $600 million settlement over Botox sales and marketing practices minimizes overhanging litigation risk.

Allergan is a recent addition to the Morningstar Wide Moat Focus Index. This index contains the 20 cheapest wide-moat stocks based on price/fair value ratios, excluding master limited partnerships and most foreign companies.