When analyzing the healthcare sector, our firm has had difficulty finding attractive companies. We have owned Intuitive Surgical (ISRG) and Idexx Labs (IDXX) for 7-8 years as well as the underlying real estate such as Health Care REIT (HCN) and Senior Housing Properties (SNH). However, outside those, operating margins in healthcare have been squeezed by 1) smaller percentage payouts to doctors and hospitals and, 2) patients delaying surgeries, procedures, and medication that are not life threatening until their financial situation improves.
So, where do you invest? In our opinion, the best place is the sometimes overlooked industry of discretionary healthcare. Similar to Nordstrom (JWN) doing well in a mediocre economy, there is always a segment of people (high net worth and ultra high net worth individuals) that buy in both up and down markets. With an aging population and an increased focus on self-image, Allergan (AGN) is in the "sweet spot" of exactly that with Botox, Latisse, and Juvederm.
Major challenges to the company include a so-called Botax, which would impose a tax on vanity procedures. So far, those attempts have failed. However, with the government searching for revenue sources, this could be revisited. In fact, there are some surveys that favor taxing these procedures because it would be another way to tax the rich. The other significant threat is the continued marketing push for Botox and the fact that Botox is growing as a percentage of total revenue. Though decade-long studies now show little to no long-term effects from the use of Botox, things can always change. As Botox is used for other purposes (sweaty palms, migraines, or overactive bladder), there is increasing risk of a lawsuit. And, with a narrower focus than the large pharmaceuticals, one regarding Botox could be very impactful.
However, there are too many reasons that Allergan is seeing 20/20 when it comes to the future. Their brands are market leaders in their respective categories, there is plenty of free cash flow for R&D, and the consistent topline growth is impressive considering most of their products are elective in nature. In addition, the financial picture is very clear. With a current ratio above 3.5 and gross profit margins of 88%, there is a great deal of flexibility on management's part to pursue acquisitions. Operating margins are a little lower than might be expected but can somewhat be explained away by global branding and increased SG&A on training doctors on Botox as a solution for migraines. At 29-30 times earnings, the stock is fairly valued now but we are betting the increased volume will result in earnings expansion over the next 18-24 months. We see the stock trading at $120 by the end of 2013.