Actavis' Wide-Moat Transformation Offers Shareholder Rewards

We think the market underappreciates the benefits and earnings potential of

From Weak Generic to Major Branded Player An astute focus on unique generic drug launches combined with opportunistic acquisitions has largely changed Actavis (formerly called Watson) from a middling generic drug manufacturer to one of the largest specialty pharmaceutical companies, with sales on par with peers like Eli Lilly LLY and Bristol-Myers Squibb BMY. Only a few years ago, Watson was a U.S.-centric generic drug manufacturer with less global scale and vertical integration than its larger global competitors Teva TEVA and Mylan MYL. Four major deals for a combined total of $105 billion since 2012 have not only improved Actavis' capabilities in the generic industry, but also made the company a major player in women's health, gastroenterology, aesthetics, central nervous system, and ophthalmology. In addition to building the women's health and gastroenterology franchises, Warner Chilcott brought Actavis a low tax rate thanks to the inversion to its Irish domicile. With the close of the Allergan acquisition, Actavis will have pro forma sales approaching $23 billion and operating cash flow in excess of $8 billion. Legacy Allergan, Forest, and Warner sales will represent approximately 36%, 16%, and 7% of Actavis' consolidated revenue, respectively. We think Actavis' competitive advantages have improved through its transformative M&A strategy.

The company's transformation has largely been spurred by a few key headwinds in the generic and branded drug markets, in our opinion. The end of the patent cliff in the United States has diminished new drug launch opportunities while extensive pricing pressure in Europe has similarly slowed growth in that region. Meanwhile, pricing pressure, less productive research and development, and large patent losses create headwinds for many pharmaceutical players. Formulation changes and other generic prevention techniques such as copay cards have had diminishing effectiveness against payers in markets with high generic alternative penetration rates, such as antidepressants and oral contraceptives.

These factors, combined with low interest rates and tax inversion capabilities, have spurred a necessary strategic shift in the specialty pharma industry, in our opinion. Consolidating large product portfolios onto an existing salesforce and cutting fruitless R&D endeavors has led to large increases in shareholder returns. We believe shareholders have benefited from firms like Actavis and Valeant VRX buying companies with weak growth prospects, such as Warner, Forest, and Medicis, and we think acquisitions of other companies could follow.

Unique Formula for Success in Pharma Industry We think Actavis' business model is a standout in the pharmaceutical market, with higher-than-average growth and profitability potential. Actavis' size (with nearly $23 billion in pro forma sales) and diversification make the company fall more into the big pharma category. However, its projected growth and profitability combined with no dividend make its financials resemble those of a biotech player. We think these benefits--being a highly diversified company on par with most big pharma players with above-average growth and profitability similar to some biotechs--currently justify a higher multiple for Actavis than for most of its pharmaceutical peers.

Actavis faces the challenges in pharma--pricing pressure, less productive R&D, and patent cliff risks--head-on through a blunt strategy of diversifying sales across numerous small products, optimizing salesforce efficiency in weak markets, and focusing R&D on franchise breadth rather than development of blockbuster Hail Marys. Actavis has largely taken Valeant's strategy, but whereas Valeant prefers to avoid primary care, reimbursable products, and R&D altogether, Actavis recognizes the market potential of unloved pharma markets where R&D can be optimized to drive organic growth supplemented with accretive acquisitions and in-licensing. Moreover, the acquisition of Allergan gives Actavis impressive new growth opportunities, especially in the ophthalmology, aesthetic, and therapeutic Botox markets. We previously forecast nearly 12.5% organic annualized revenue growth for Allergan over the next five years, which should support high-single-digit growth for Actavis once Allergan is consolidated.

Actavis Gets Wide-Moat Upgrade With Acquisition of Allergan Through acquisitions, Actavis has transformed into a globally diversified drug manufacturer with considerable low-cost advantages (economies of scale) and intangibles (patent-protected products and a healthy pipeline). Actavis previously boasted a strong narrow moat thanks to enhanced profits from combining the large primary-care drug portfolios of Warner Chilcott and Forest Labs. Now combined with highly defensible products and unique pipeline assets from Allergan in the specialty ophthalmology and aesthetic markets, Actavis has created a unique wide-moat firm in the pharmaceutical sector, in our opinion.

Diversification Limits Patent Exposure Risk With the Allergan deal, Actavis is now broadly diversified, with no major patent risks tied to product concentration. When Namenda succumbs to generic competition in mid-2015, Actavis will have only two products exceeding $1 billion in revenue: Botox and Restasis. Botox will become Actavis' largest product at nearly 10% of sales, but its low generic and branded competition risks combined with its numerous indications help diversify this product's cash flows. Although management has transitioned more than 40% of patients to its new extended-release version of Namenda, we think market share will be difficult to sustain now that a federal court has struck down Actavis' ability to discontinue selling the older Namenda IR formulation. We therefore anticipate that sales for the Namenda franchise will fall once generic competition enters in the middle of this year on the older Namenda formulation.

Defensible Products, Specialty Markets Limit Pricing Pressure, Generic Entrants Complex manufacturing and regulatory hurdles for a number of products Actavis is inheriting from Allergan create defensible markets from generic and branded competition.

Botox (10% of sales, 10% five-year compound annual growth rate). High barriers to entry in the neurotoxin market have enabled management to defend Botox's global market share, which stands near 76%--a trend we think Actavis can preserve. Botox is a complex biologic molecule with essentially no risk of generic competition thanks to complex manufacturing and regulatory requirements in addition to customer brand recognition and physician injection familiarity. However, multiple branded competitors have entered the market. The lack of interchangeability among these molecules, unique physician training and injection requirements for each toxin, modest price competition, and the use of physician and customer loyalty programs have helped keep switching costs for patients and doctors relatively high. Although Botox does face competition for its largest indication--the cosmetic removal of facial wrinkles--management has expanded its market into numerous therapeutic categories where it essentially enjoys a monopoly thanks to large clinical trial requirements and expensive up-front physician training costs. From our perspective, there's also minimal risk of new disruptive entrants.

Fillers, implants, and other aesthetic products (12% of sales, 10% five-year CAGR). The Botox brand has enabled management to build a difficult-to-replicate aesthetic product portfolio, including facial fillers, breast implants, and other skin-care products. Much like Botox, these products are regulated as devices and face no risk of generic competition. Physician product familiarity combined with broad product scope and rebate programs helps keep brand loyalty high. The aesthetics market is a concentrated oligopoly with Johnson & Johnson JNJ and Actavis accounting for most of the global market.

Ophthalmology (16% of sales, 9% five-year CAGR). Ophthalmology drugs require more complicated manufacturing techniques than conventional drugs and require small clinical trials to prove bioequivalence. Restasis, Allergan's $1 billion dry-eye drug, for example, faces a low threat of generic competition thanks to a complicated emulsion formulation and large and complicated clinical trial requirements to prove efficacy. We also expect limited branded competition in the dry-eye market. There's more generic risk to Allergan's glaucoma products, but recent favorable patent rulings on Lumigan and Alphagan and innovative line extensions in current clinical trials should prevent severe price erosion in the future.

Product Pipeline Supports Stable Growth Prospects Actavis' R&D strategy will not mimic that of most big pharma and biotech peers. Instead of high-risk drug discovery, Actavis is likely to stick to product breadth in specific therapeutic areas where management can optimize salesforce productivity. We speculate, however, that a heavy reliance on acquisitions, partnerships, and licensing deals combined with some internal innovation in high-return areas will enable Actavis to expand into new markets over time. For example, recent acquisitions of Furiex, Aptalis, and Rhythm have added products to Actavis' gastrointestinal franchise, while Durata extends Actavis' presence in antibiotics. Management has also not shied away from selling assets to boost efficiency.

Largely inherited from Allergan, ophthalmology devices, new dry-eye products, novel biological neuromodulator formulations, and biosimilars (through a partnership with Amgen AMGN) remain attractive internally developed products. Additionally, the manufacturing and regulatory hurdles for these products should further protect Actavis from generic competition, thereby enhancing the economic moat potential of the company's future drug portfolio.

Ophthalmology biologics ($4 billion-plus market opportunity). Allergan's anti-VEGF DARPin products, developed by and licensed from Switzerland-based Molecular Partners, have the largest market potential for the company's near-term pipeline, in our view. Designed ankyrin repeat proteins, or DARPins, are a small, highly potent, and very stable alternative to antibodies, including simpler manufacturing and protein targeting processes. Allergan estimates that its anti-VEGF DARPin products would require an approximate quarterly injection frequency, a considerable improvement over current anti-VEGF treatments that require monthly injections (Roche's RHHBY Lucentis) and bimonthly injections (Regeneron's REGN Eylea). We think the first DARPin molecule is likely to enter Phase III trials by 2016. Molecular Partners can earn as much as $1.4 billion in milestone payments plus tiered royalty payments under the partnership to develop ophthalmology-related DARPin products.

Ophthalmology devices ($1 billion-plus market opportunity). We think Allergan's sustained-release eye medication delivery device, Novadur, holds promise in indications such as macular edema, glaucoma, and wet/dry age-related macular degeneration, with market potential of $500 million-$1 billion or more per indication. Novadur is a polymer matrix drug delivery system that is directly injected in the eye and slowly dissolves, releasing the included drug. The Novadur device, which can last from three to four months, ensures better patient adherence and improved therapeutic outcomes as opposed to current conventional eye drops. Ozurdex, Allergan's first drug to use Novadur, is a corticosteroid indicated for the treatment of macular edema (including the diabetic form) and noninfectious uveitis.

Neuromodulator derivatives ($2 billion-plus market opportunity). We think Actavis will continue to pursue development of Botox and new neuromodulator formulations. One such novel formulation, Senrebotase, is an altered form of Botox that targets only pain nerve cells. Unlike Botox, which affects pain, motor, and sensory nerves, Senrebotase can diminish pain without the side effect of muscle paralysis. The benefit of a localized pain-management injection with a prolonged multimonth effect is a considerable market opportunity, in our view, especially without the abuse and addiction potential associated with current opioids classified as controlled substances.

Restasis and other dry-eye drugs ($1 billion-plus market opportunity). We imagine that Actavis will also continue to develop new formulations of Restasis and other novel dry-eye drugs under development to ensure the company's ongoing lead in this important and limited-competition ophthalmology market.

Biosimilars ($2 billion-plus market opportunity). Thanks to its partnership with Amgen, we think Actavis possesses strong odds of succeeding in the emerging biosimilars market. Biosimilars, or near bioequivalents to branded biotech drugs, face extensive development, manufacturing, and regulatory hurdles to gain approval in addition to large marketing costs to convince physicians to prescribe these products. (We think automatic substitution and interchangeability with branded versions remain unlikely in the medium term.) Under its partnership with Amgen, Actavis has biosimilar versions of Erbitux, Rituxan, Avastin, and Herceptin under development.

Core Therapeutic Segment Leadership Boosts Salesforce Productivity Actavis' ability to scale a broad portfolio of drugs across a narrow field of therapeutic areas helps improve marketing efficiency. Thanks largely to the acquisition of Forest, Actavis has a large primary-care salesforce in addition to a significant presence in the aesthetic and ophthalmology segments from the acquisition of Allergan. Adding new products to this existing infrastructure could add high incremental profitability in areas where Actavis has critical mass. We expect management to continue to diligently license, acquire, and develop products in the company's key areas of ophthalmology, aesthetics, gastroenterology, central nervous system, and women's health. Anti-infectives are a small part of Actavis' focus, but may grow as the company plans to expand its hospital business along with its generic injectable drug business and eventual participation in the biosimilars market.

Complex Generic Capabilities Supplement Scale and Vertical Integration In the generics segment, Actavis derives its narrow economic moat primarily from economies of scale as one of the largest pharmaceutical manufacturers in the world. After the close of the Watson-Actavis merger in the fourth quarter of 2012, Actavis became the third-largest generic drug manufacturer and solidified its ranking as a generics industry leader along with Teva, Sandoz (a subsidiary of Novartis NVS), and Mylan. We estimate that these four companies have nearly 50% of the global retail generic industry market share and, thanks to economies of scale, enjoy a low-cost manufacturing advantage over smaller players. Actavis still lags behind the scale and vertical integration of its peers, in our opinion, but management has wisely pursued niche drug categories or complex generics, which have helped boost growth and profitability. Higher manufacturing or regulatory approval requirements for these products help limit competition, which in turn leads to longer periods of profitability than typically seen with more conventional generic drugs. We estimate that operating margin on some of Actavis' key generic products like Lovenox, Lidoderm, and Concerta could be as high as 60%. Additionally, Actavis' low tax base helps keep overall operating costs low.

Shares Appear Undervalued Given Earnings Growth Potential We think Actavis' shares are undervalued when we take into account the company's wide economic moat, above-average growth profile, and extensive margin expansion from cost synergies. Our $330 fair value estimate implies a price/earnings multiple of approximately 20 times 2015 earnings, which seems reasonable compared with peers, given Actavis' growth, profitability, and diversification. Taking into account the combined earnings potential from approximately $1.8 billion in cost synergies between Actavis and Allergan, adjusting our fair value estimate for the time value of money implies a multiple of about 16.7 times forward 2017 earnings, which we think remains on par with mature peers in the pharmaceutical industry.

With pro forma sales near $23 billion and an organic growth rate in the high single digits (largely thanks to Allergan's assets), Actavis will be one of the fastest-growing pharmaceutical companies of its size. Additionally, we think the long visibility into products like Botox, Restasis, facial fillers, and breast implants, combined with Actavis' overall product diversity, diminishes investment risk. Our revenue forecasts for major drugs like Botox, Restasis, and Lumigan are in line with consensus. Additionally, the company's strong pipeline on the branded, biosimilars, and generics sides of the business supports healthy long-term growth prospects, in our view.

Acquisitions, International Expansion Offer Opportunities Management's lack of enthusiasm for high-risk internal drug discovery doesn't require the high levels of R&D spending typically seen at pharmaceutical and biotech firms--a strategy we think makes sense in many of Actavis' primary-care markets. Acquisitions and licensing agreements are likely to play a central role in supplementing Actavis' relatively low spending on R&D. We imagine that reasonable internal R&D spending in higher-stakes areas of ophthalmology and neuromodulators will continue.

While Actavis' generics segment is fairly globally diversified, the company's branded segment remains heavily concentrated in the U.S. market. We think this creates some opportunity for the company to leverage its existing global generic operating footprint to expand its existing branded products overseas. Actavis' strength in Eastern Europe and Russia combined with Allergan's strength in Western Europe and Latin America should create moderate revenue synergies.

Cost Synergies Optimize Profitability With an estimated $1.8 billion, $1.0 billion, and $400 million in total cost synergies from the Allergan, Forest, and Warner deals, respectively, we think Actavis can eventually produce an EBITDA margin over 40%, which is one of the highest in the pharmaceutical industry (albeit still below most biotechs). Management already appears to be successfully integrating Warner and Forest, and we place a high probability on management meeting its goals with Allergan. We think management can sustain high profitability by continuing to expand the breadth of its product portfolio into a relatively stable salesforce while focusing only on high-value R&D efforts. A beneficial product mix from higher growth in Actavis' branded segment should also naturally lead to consolidated margin expansion over time. Additionally, the company's tax inversion through Warner Chilcott boosts operating cash flow, which we think can easily exceed $8 billion on a pro forma basis. We do model a small portion of that cash flow, at about 2% of sales, being utilized every year to acquire new pipeline products and supplement the company's low internal R&D spending. Our revenue and margin projections result in an adjusted earnings per share CAGR of nearly 15% through 2019. Additionally, upgrading Actavis' moat rating to wide from narrow extends the length of economic profits in our discounted cash flow model.

Diversification Supports Low Cost of Equity Thanks to Actavis' $23 billion in diversified pro forma revenue and wide economic moat, we've reduced our cost of equity for Actavis to 8%, which is predominantly shared by all major pharmaceutical and biotech companies we cover. Although a larger portion of Allergan's cash-pay products are more sensitive to macroeconomic conditions, these products compose only about 10% of Actavis' pro forma business now that the deal has closed. Moreover, many of Allergan's cash-pay products cater to a more affluent customer base, which has kept revenue growth relatively stable, even during the last recession. Overall, Actavis will become as diversified, if not more so, as many of its peers. We also think the 8% cost of equity is acceptable given the likelihood of financial deleveraging after the Allergan deal. We think large acquisitions are possible in the future but not likely in the near term, as management appears committed to maintaining an investment-grade debt rating.

Few Risks to Investment Thesis Guide Low Uncertainty Rating We foresee few major risks to our investment thesis on Actavis. Overall, Actavis' scale, diversification, and durable products diminish cash flow swings from patent losses. However, there are a few things to watch.

Although we think generic risks are relatively low for Actavis, we do think new branded competitors could eventually disturb some of the firm's key markets, in particular ophthalmology or aesthetics. We currently see little disruptive potential from possible pipeline products.

A large determinant of success for Actavis' acquisition of Allergan will depend on the eventual launch of products like the anti-VEGF DARPin and extended-release Lumigan, in our opinion. If these drugs or their biosimilars fail to win regulatory approval, Actavis' growth prospects will diminish.

We doubt that the U.S. Congress or international government tax havens such as Ireland will significantly change tax regulations anytime soon. Though the recent U.S. Treasury Department rules may dissuade future tax inversions, we think established tax inverters, such as Actavis, Valeant, and Endo ENDP, are best positioned, especially since any retroactive penalties seem highly unlikely.

Actavis' rapid acquisition pace will require strong execution to hit expected cost synergies as well as possible revenue synergies as the firm looks to dissipate its U.S. branded pharma concentration. We take some solace in the fact that CEO Brent Saunders has had fairly strong experience in Actavis' key markets of ophthalmology, gastroenterology, and CNS during his stints leading Bausch & Lomb and Forest. Expensive acquisition price tags and financial leverage also remain concerns, but we think management intends to uphold credit quality while focusing on shareholder returns. We appreciate that management is willing to back away when necessary, as evidenced by the recent decision to sell a large portion of its Western European generics operations in addition to the recent divestment of respiratory products to AstraZeneca AZN.