This morning, Allergan (AGN) reported second-quarter results that missed on the headline but were in line with consensus when adjusting for the company’s recent $500 million sale of generics distributor Anda (which is separate from its broader, $40.5 billion, generics sale), the revenue and earnings of which were excluded from the company’s second-quarter and full-year 2016 results.
Following the end of the conference call, we emerged confident in the company’s enviable strategic positioning, strong fundamentals and visibility -- all of which appear to be lost on the market, which prioritizes catalysts over consistency. Although restricted, we would recommend adding to the position at current levels, for those willing to take a long-term view. We reiterate our medium-term price target of $270, but see upside to $325 on a 12-to-16-month basis.
Before digging into the details, let’s first address a simple reality: The market has a tendency to revert to inefficiency in the absence of context or patience. Some our own investment mistakes have been made when we allowed emotions to dictate our investment decisions. Many of our investment successes came as a result of our ability to recognize the role emotions play in clouding investment decisions -- and shifting focus towards cerebral analysis, conviction and discipline. We constantly draw upon prior experiences -- the bad and the good -- to influence how we evaluate future decisions.
As our team evaluates Allergan’s results, the conference call and the abundance of prior diligence which helps provide context amid some confusion. We view the shares as fundamentally undervalued and largely misunderstood. The misunderstanding is two-fold: inaccurate consensus estimates and a lack of defined shareholder base.
First, the vast majority of sellside research analysts failed to update their sales and earnings models ahead of today’s results. When the release hit the tape, investors saw jarring headlines, including:
--“Allergan reports Q2 revenue $3.68 billion, consensus $4.1 billion” (Bloomberg alert)
--“Allergan sees FY16 adjusted EPS $13.75-$14.20, consensus $14.21. Sees FY16 net adjusted revenue $14.65-$14.9B, consensus $16.63B” (Bloomberg alert)
--“Allergan misses second quarter sales forecasts” (Financial Times)
Undoubtedly, Allergan did miss consensus results for both second-quarter and full-year 2016 estimates. But this is down to a mistake made by sellside research analysts, the vast majority of which failed to exclude the revenue and earnings contribution of its divested Anda business from the 2Q and FY16 earnings models.
For context, “consensus” estimates are simply an aggregation of sellside research analysts’ sales, EPS, and sometimes cash flow, estimates. The research analyst covering a company will receive a “consensus request” message from a consensus aggregator (Thomson Reuters and Bloomberg, for example) which asks the analyst to provide his or her estimates. Depending on the situation, the analyst typically has access to the existing consensus estimates through various channels (in rare cases, the analyst runs completely blind). The analyst can elect to respond to the request -- it may serve as a reminder that the analyst needs to update his or her respective model -- or ignore it altogether.
The consensus request can sometimes turn into an adapted game theory: No analyst wants to be too far out of consensus, so many tweak their own valuation models, adjusting several levers until it fits quarterly earnings within the consensus range. The goal is to avoid being “out of consensus,” especially when it comes to nuanced situations.
Heading into Allergan’s 2Q results, consensus stood at $4.1 billion/$16.6 billion in Q2/FY 2016 sales and $3.29/$14.21 in 2Q/FY EPS. For the most part, the sellside herd mentality settled around these estimates, which is why the “miss” appeared to be striking.
In reality, Allergan’s second-quarter and full-year results and forecast excluded the sales/earnings contribution from the $500 million asset sale. Analysts at J.P. Morgan were one of the few that updated their model ahead of the print for the divestiture, lowering its 2Q sales estimates by $420 million, full-year sales by $1.6 billion and full-year EPS by $0.15. Bernstein was another exception, accurately forecasting the quarterly and annual results.
When normalizing for Allergan without Anda, which is a pure-play branded pharma, its results and forecast were strong across the board: Each of its top seven franchises reported double-digit sales growth, driven by Botox (+16% year-on-year), Restasis (+21%) and Fillers (+18%).
To illustrate the some of the issues on the sellside, Credit Suisse’s combined forecast for Restasis and Botox sales were $100 million below actual results, and its forecast failed to account for the $500 million publicly announced Anda sale.
The second factor weighing on shares involves an undefined shareholder base. After undergoing a radical transformation over the past year, Allergan has emerged streamlined, methodical and focused on building upon existing leadership across each area in which it competes. Its legacy business model was a hedge fund magnet, with event-driven traders piling in ahead of various “catalysts” -- the Pfizer merger and completion of Teva generics sale being the two biggest.
Its business model is no longer one that appeals to catalyst-driven traders, rather to long-term value investors. Unfortunately, in order for the company to attract this lucrative institutional shareholder base, it must prove itself by delivering on the thesis it has laid out quite explicitly: Allergan offers a best-in-class branded growth profile (boasting nearly 10% and 15% annualized EPS growth), with significant upside potential to earnings over time, as operational leverage, capital deployment and upward re-rating become commensurate with the top-tier growth profile it possesses, which is among the best in major pharma.
Future growth will be driven by several key new product launches and a broad late-stage pipeline. CEO Brent Saunders bases every decision in the context of maximizing shareholder value creation. The $33.4 billion net cash windfall following the sale of its generics business to Teva is fodder for takeover speculation. However, Saunders and his management team have made it clear that they have neither interest, nor need, for any large-scale M&A. Their capital deployment priorities -- laid out multiple times over the last several months -- remain paying down debt to maintain an investment-grade rating (which the company has already completed, bringing interest expenses down considerably), buying back shares aggressively and opportunistically ($5 billion of its $10 billion buyback authorization is already in play), and bolstering therapeutic leadership in the seven areas in which it competes.
The last point cannot be lost on investors, as it intends to bolster its therapeutics leadership by investing internally -- concentrating on sales and marketing spend behind product launches, R&D to widen its existing leadership and finally, tuck-in acquisitions, which Saunders labeled “stepping stones.”
Bottom line: Large, transformational M&A is explicitly nullified. A mixture of debt paydowns, buybacks, and investing in existing and future brands are explicit areas of focus. Each dollar invested will be dictated by return on investment, and evaluated through the lens of a decade-plus sustainable growth trajectory.
We view Allergan as a buy, at current levels, for anyone with a minimum 8-to-12-month investment horizon, as it will take time for the company to grow into its full and fair valuation: $270 a share in the medium-term (or 16x next year’s conservative earnings estimate of $17.10 a share) and $325 a share over a 12-to-16- month horizon (based on 15x our 2018 EPS estimate of $21 a share). You can be assured that Saunders and team will be buying back, alongside.