Allergan Still Undervalued

We think Allergan’s diverse portfolio of defensible products, broad pipeline, and future potential acquisitions 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.

Although large deals may sporadically continue, we expect Allergan will remain focused on expanding its branded pipeline and salesforce productivity through small acquisitions and licensing partnerships. For example, recent 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 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 AMGN for developing biosimilars, which face stringent manufacturing, regulatory, and marketing hurdles. The partnership includes biosimilar versions of Erbitux, Rituxan, Avastin, and Herceptin.

Industry Leader in Specialty Markets We think Allergan possesses a wide economic moat. Management's recent decision to sell the generics segment does not detract from the moat, in our opinion, since we viewed Allergan's branded segment assets as 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, thereby enhancing its moat more than if it had retained its generics unit.

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 portfolio is also broadly diversified, with only two products exceeding $1 billion in revenue following generic competition on Namenda in 2015: Botox and Restasis. These two drugs should account for nearly 20% and 10% 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, supplemented by acquisitions and partnerships to enhance the portfolio and push into new therapeutic categories. With more than $20 billion in cash at the firm’s disposal following the generic unit sale and debt repayment, acquisitions should eventually improve growth opportunities and increase product diversification, which helps minimize patent cliff concerns.

With over $2 billion in annual sales, Botox has been a critical contributor to Allergan’s wide moat in its aesthetics franchise. 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%. Additionally, Allergan’s facial fillers and breast implant franchises are regulated as devices and also face limited competitive risks due to similar regulatory and marketing hurdles.

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 introduce even greater manufacturing complexity, which should help reduce the long-term risk of generic competition.

Healthy Risk Profile Despite Less Diversification Acquisitions have greatly diversified Allergan's product portfolio and drug pipeline, which helps allay the risk of losing key products to generic competition. Future large acquisition are a possibility, placing pressure on management to not overpay and successfully integrate acquisitions. In the meantime, the sale of the generics business in 2016 has enabled Allergan to dramatically reduce its debt load.

We’ve changed our fair value uncertainty rating to medium from low following the recent divestitures of the generics and distribution businesses, which represented about $6.5 billion in combined sales. Despite Allergan’s less diversified operations after parting ways with these businesses, we still think Allergan’s large cash-pay aesthetics business, long window of patent protection on most key assets, innovative pipeline, and improved balance sheet give the company a healthy risk profile.

Management tends to prefer less risky product development than its Big Pharma peers, but over the long term, internal development and acquisitions of pipeline products will remain essential for growth. 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 affect growth potential. The integration of assets among Allergan, Warner, and Forest also provides a potential launching pad for expansion into new categories.

We consider Allergan to have reasonably strong financial health. The sale of Allergan’s generics and distribution units has dramatically improved liquidity. Teva bought the generics segment for roughly $40.5 billion ($33.75 billion in cash and $6.75 billion in equity subject to a 12-month lockup period), which mostly offsets Allergan’s current $42.7 billion debt balance at the end of 2015. Management plans to use nearly $10 billion in cash to pay off debt, and the board has authorized $10 billion in share repurchases. Management remains committed to maintaining its investment-grade credit rating, and the company currently maintains a net debt/adjusted EBITDA of approximately 0.75.