Allergan Looks Cheap as Pfizer Deal Approaches

We think wide-moat

Allergan also looks considerably undervalued on a stand-alone basis at our pre-Pfizer deal fair value estimate of $370, as its performance continues to mostly track our expectations. Management plans to halt efficiency and cost-saving initiatives until after the Pfizer deal closes, which should temporarily slow earnings per share growth below our initial expectations. Additionally, our initial EPS estimate incorporated more debt repayment from the cash proceeds of the Teva transaction than management's current plan to pay off $8 billion in term loans before the Pfizer deal. Regardless, the company's adjusted EBITDA and operating cash flow of $2 billion and $1.6 billion during the fourth quarter put Allergan roughly on track with our previous forecasts.

Management's estimate for nearly $17 billion in revenue for 2017 falls about $500 million short of our forecast, but we don't see material shifts in our discounted cash flow model. The shortfall stems from a $500 million decline in Allergan's drug distribution business because of CVS' acquisition of Target's pharmacies at the end of 2015. This revenue shortfall should have little material effect on our cash flow projections, though, since Allergan's distribution business has a low margin and constitutes less than 2% of consolidated adjusted operating income. Management also anticipates about a $200 million currency headwind in 2016, but new product launches--especially the recent launch of Viberzi in irritable bowel syndrome with diarrhea--should help sustain strong underlying growth.

Additionally, many of Allergan's existing franchises continue to post strong results. Botox, Restasis, facial fillers, and Linzess posted pro forma constant-currency growth of 15%, 19%, 15%, and 39% during the fourth quarter, for example. Although we do expect slower performance for Restasis as Shire SHPG potentially launches Lifitegrast later this year, we also still see fairly limited branded and generic competitive risks for this product, especially as Allergan's planned launch of a multidose preservative-free version later this year should help defend its market position and intellectual property.

Healthy Earnings Growth Ahead Allergan (previously called Actavis) has used acquisitions to transform into a major pharmaceutical contender. We think the firm's diverse portfolio of defensible products and broad pipeline will sustain healthy earnings growth.

The acquisitions of Warner Chilcott and Forest Labs greatly enhanced the company's branded drug portfolio with a significant presence in the primary-care markets of women's health, gastrointestinal, urology, and central nervous system therapeutics. Meanwhile, Allergan's considerable scale in niche markets of ophthalmology and aesthetics offers a long runway for growth thanks to defensible products (especially Botox) and an attractive pipeline. Potential cost synergies from these deals, including a dramatically lower tax rate, should also drive strong earnings growth in the near term.

We expect Allergan will remain focused on expanding its branded pipeline and salesforce productivity. Deals for Furiex and its recently approved drug Viberzi for irritable bowel syndrome with diarrhea, oral CGRP molecules from Merck for migraine, NMDA modulators for depression from Naurex, Kythera to enhance the facial aesthetic franchise, and Durata for new innovative antibiotics should provide new growth opportunities. New dry eye and glaucoma products in development along with the Allergan's licensed anti-VEGF DARPin in Phase II trials for wet age-related macular degeneration should help preserve Allergan's leadership in ophthalmology. In our view, Allergan also has one of the stronger industry partnerships with Amgen for developing biosimilars, which face stringent manufacturing, regulatory, and marketing hurdles. Their partnership includes biosimilar versions of Erbitux, Rituxan, Avastin, and Herceptin.

Leader in Ophthalmology and Aesthetics We think Allergan possesses a wide economic moat. Management's decision to sell its generics segment does not detract from the moat, in our view, since we viewed Allergan's branded segment assets as having a solid wide moat on their own. In fact, we think Allergan's large cash position following the sale will enable management to reinvest capital in its branded business, enhancing its moat further. Likewise, the combination with Pfizer should only strengthen Allergan's moat.

Allergan possesses an industry-leading portfolio in the specialty markets of ophthalmology and aesthetics, which enjoy much higher barriers to entry and lower risk of generic competition than most pharmaceutical products. The company also has an extensive presence in the primary-care market, with a significant ability to leverage new products in its portfolio with little incremental cost. Allergan's product portfolio is also broadly diversified, with only two products exceeding $1 billion in revenue following generic competition to Namenda in 2015: Botox and Restasis. These two drugs should account for nearly 16% and 8% of consolidated revenue, respectively, following divestment of the generics business. We think management will mostly preserve Allergan's historical product innovation, which should help keep pricing and market share healthy.

With over $2 billion in annual sales, Botox has historically been a critical ingredient of Allergan's wide moat. Neurotoxins like Botox require complex manufacturing processes, and as biological compounds, they also require expensive clinical trials in order to receive approval from the U.S. Food and Drug Administration. Additionally, because each injectable neurotoxin has unique characteristics and produces different effects, doctors and patients remain hesitant to switch brands--a significant difference from competition on most drugs. To date, only two other neurotoxins have been approved for use in the United States. Although Botox does face competition for its largest indication--the cosmetic removal of facial wrinkles--management has expanded Botox's 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 global market share, which stands near 76%.

Allergan's eye pharmaceuticals and skin ointments also 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 keep heavy competition away. We imagine Allergan can maintain a historical success of fending off most generic threats through patent litigation and new product launches. Favorable patent rulings for Lumigan and Alphagan in addition to manufacturing complexity and newly issued patents for Restasis greatly diminish the odds of near-term generic competition for these drugs, in our view. Moreover, we think Allergan's pipeline of injectable devices, biologic products, and reformulated neuromodulators, which introduce even greater manufacturing complexity, should help reduce the long-term risk of generic competition.

Diversity Allays Risk Allergan's acquisitions have greatly diversified the company's product portfolio and drug pipeline, which helps allay the risk of losing key products to generic competition. The sale of the generics business should enable Allergan to reduce its debt load, but successfully integrating acquired businesses will likely remain management's most critical task for near-term success. We think the risk of government issues blocking the Pfizer deal is low.

Other than Namenda in 2015, most of Allergan's key products don't face patent expiration until well after 2020. Restasis could be a near-term challenge for management, but we think the possibility of upheld patents and manufacturing complexity on this drug should limit competition. We also think Allergan's pipeline can help the company salvage its lead in the dry eye market even with the possibility of limited branded competition in the near term. While we still hold a favorable outlook for many of Allergan's pipeline products, pipeline failures for certain key drugs could severely affect growth potential. The integration of acquired assets also provides a potential launching pad for expansion into new categories. We expect the Pfizer merger will significantly improve Allergan's credit profile, which has been negatively affected by merger and acquisition activities in recent years.