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Nicholas Coppola, CFA
March 25, 2019
Last week, we added Allergan (AGN) to portfolios, which we view as an inexpensive stock offering an attractive risk/reward profile for patient investors. As a matter of quick background, Allergan is a global pharmaceutical company that focuses on four therapeutic areas, including medical aesthetics, eye care, the central nervous system, and gastroenterology. Going forward, we expect the medical aesthetics business to benefit from strong brands in a growing and underpenetrated cash-pay segment of the industry. We are also hopeful that their pipeline of new products can exceed expectations, which in our view are set fairly low, providing an easier hurdle to be cleared. Our note also acknowledges recent headwinds that we believe are already baked into the stock price, with AGN trading at just ~9.2x trailing ex-items earnings in comparison to the broader S&P 500 at ~18.5x.
To start with medical aesthetics, we see this as a growing and resilient business with high barriers to entry. In FY’18, medical aesthetics grew ~13% YOY to $4.3B and made up a substantial ~27% of revenues. Segments of the business can be broadly categorized as facial aesthetics, plastic surgery, regenerative medicine and body contouring, with their largest products including Botox Cosmetics and Juvederm fillers. Importantly, this is typically a cash-pay business and, as a result, is less subject to the well-publicized pricing pressures in other parts of the pharmaceutical industry. We also believe that Botox is a particularly strong brand that is often asked for by name, making it essentially the ‘Kleenex’ of botulinum toxin injections. While there are new competitors entering the field (i.e., Revance Therapeutics & Evolus), we believe that Botox’s iconic brand, as well as their cumulative investments in sales and training, will help to mitigate this impact. And importantly, we think that customers who literally have their face on the line will most frequently choose a product with a long history of safety and efficacy rather than opt for a new entrant. Additionally, through Allergan’s acquisition of Zeltiq in 2017, the company added the CoolSculpting fat-freezing procedure to their portfolio. This is currently a small but growing part of their business representing ~11% of medical aesthetics revenues. Post-acquisition, Allergan has accelerated systems installations in both domestic and international markets. This should prove to be a longer-term tailwind, since systems produce recurring revenue on consumables, and thus leverage their business to usage.
To put some numbers around long-term expectations, management expects to grow medical aesthetics sales to ~$7B - $8B by 2025, implying a ~7% - 9% compound annual growth rate. Helping to drive this growth, the medical aesthetics industry is meaningfully under-penetrated, with far more people interested in their products than those currently served. To put this in context, Allergan indicates that ~7% of aesthetics considerers have used facial injectables worldwide, implying significant room to expand the market and reach new customers. Consistent with this, management, at their investor day last year, announced their intention to more than double their direct-to-consumer advertising spend with the goal of driving customer acquisition.
So what about their pipeline? In our view, innovation is critically important in the pharmaceutical industry, as companies will always have some mixture of patent expirations and pipeline opportunities, with new products required to backfill lost volumes. Encouragingly, management is looking for ~1-2 product launches per year for the next several years, with a number of drugs and devices in late stage development. To name a few, these include Abicipar for age related macular degeneration, Atogepant for prophylaxis migraine, Bimatoprost SR for glaucoma, Ubrogepant for acute migraine, and Vraylar in a new indication for bipolar depression. Surely there is risk involved here, and not all new drugs will be winners, even among those closer to the finish line. In fact, there was a disappointing reminder of this dynamic just several weeks ago when the company announced Rapastinel for major depressive disorder failed phase 3 trials.
Thematically, we believe that pharma companies create value to the extent they develop novel and differentiated drugs that have an impact on patients’ lives. Allergan is devoting resources to this cause, with ~2,150 employees supporting R&D and expectations to invest between ~$1.6B - $1.7B in their pipeline in 2019. While the success of this R&D spend is highly uncertain, from an investor perspective, we are encouraged that expectations among analysts appear to be fairly low. As previously discussed, this may be setting up for an easier hurdle.
If you are wondering how such a stock could be trading at the low price of ~9.2x trailing ex-items earnings, there are a number of reasons for investor caution that have impacted shares. First, one of the company’s most significant drugs, Restasis for dry eye, which made up ~8% of revenues in FY’18, is expected to soon lose exclusivity. With generics entering the market, a precipitous decline in sales of the product is expected. Additionally, Botox has new competition looming on the horizon that may impede growth. Botox is Allergan’s largest product, representing ~23% of sales. But to add some nuance to this, the cosmetics portion that we view as most immediately threatened by competition is somewhat smaller at ~10% of sales. And we would reiterate that Botox is the premium and established brand in the category, which we view as an important competitive advantage in a growing industry. We would also point out that Botox is already approved for a wide variety of cosmetic (i.e., glabellar lines, lateral canthal line, forehead lines) and therapeutic indications (i.e. migraine, bladder dysfunction, focal spasticity) that competitors are far from matching. In terms of expected financial performance this year, factoring in a number of headwinds including losses of exclusivity and two recalls, management expects revenues to be ~$15.0B - $15.3B, representing a ~3-5% decline from the prior year. Consensus estimates call for mid single-digit revenue and high single-digit earnings growth to resume thereafter, making this potentially a year of transition for the company.
Going forward, capital allocation has been described in order of priority as 1) reinvest in their four key therapeutic areas, 2) debt reduction with a commitment to reach 2.5x net debt/EBITDA by the end of 2020 (compares to 2.8x currently), 3) fund dividends with a commitment to annual increases, and 4) opportunistic share repurchases (which we view favorably given the current stock price and our outlook). Management is also strategically narrowing their focus with fewer therapeutic areas. As a recent example, management plans to sell their anti-infectives business in the near-term, with an expected fair value of ~$885MM. The company also recently explored selling their Women’s Health business, but refrained from doing so as a result of insufficient bids. And looking back into the highlight reel of previous capital allocation decisions, we applaud management’s sale of their generics business to Teva Pharmaceutical in August 2016, which helped the company pay down debt and steer clear of competitive pressure in the generics industry.
With all that said, buying at the right price is a large portion of the investing battle. And with AGN trading at just ~9.2x adjusted trailing twelve month earnings vs. the S&P 500 at ~18.5x, we think there is a sufficient margin of safety for investors. In fact, based on our internal DCF analysis, we currently estimate intrinsic value at close to ~$220. In short, while there are certainly a number of risks to the story, we believe that the risk/reward profile is skewed to the positive.
Thank you again for your continued trust and please let us know if you have any questions regarding Allergan or your larger portfolio.
Nicholas Coppola, CFA
Senior Portfolio Manager