Moody's is still overstating the credit risk of Allergan plc (NYSE:AGN) with its Baa3 rating. Our fundamental analysis highlights a much safer credit profile for AGN, whose strong cash flows cover all their obligations including debt maturities through 2022. Moreover, their sizable expected cash build should allow them to service all obligations including debt maturities if their cash flows ever fall short. We therefore rate AGN three notches higher at an IG3- credit rating, or an A3 equivalent using Moody's ratings scale.
Cash bond markets are also overstating credit risk with a cash bond YTW of 2.938% relative to an Intrinsic YTW of 1.458%, while CDS markets are accurately stating AGN's credit risk with a CDS of 36bps relative to an Intrinsic CDS of 19bps.
Cash Flow Profile
We produce a chart for Allergan plc, as we do for every company we evaluate. The chart provides a far more comprehensive view of credit fundamentals than traditional ratio-based analyses. It shows the cash flow generation and cash obligations related to the credit of the firm, adjusted for non-cash financial statement reporting distortions from GAAP. The blue line indicates the gross cash earnings (Valens' scrubbed cash flow number) expected to be generated based on consensus analyst estimates and Valens Credit's own in-house research team. The blue dots above that line include the cash available at that time while the blue triangles indicate that same amount plus any existing, available lines of credit.
The colored, stacked bars show the cash obligations of the firm in each year forecast. The most difficult obligations to avoid are at the bottom of each stack, such as interest expense. The obligations with more flexibility to defer year to year, such as pension contributions and maintenance capital expenditures, are at the top of the stacked bars. All of the calculations are adjusted for non-cash distortions that are inherent in GAAP accounting, including the highly problematic and often misused statement of cash flows.
If the company generates and has cash levels that are above their obligations, the risk of default is extremely low. Even if the cash generated yearly is close to the levels of the stacked bars, a company generally has the flexibility to defer payments of various kinds. For example, they can allow assets to age a little longer, or they can cut certain maintenance costs such as maintenance capex. While decisions such as those can create other business concerns, the issue in credit risk is simply this: Does the company have enough cash to service their credit obligations?
AGN's cash flows would substantially exceed all obligations including debt maturities through 2022. Additionally, if the firm were to experience a drop in cash earnings, their excellent liquidity profile (bolstered by the sale of their generic drug business to Teva Pharmaceutical Industries) indicates that they would have no issues servicing their debt obligations. AGN's ability to service their debt maturities with cash is important because their weak asset backing drives a non-existent recovery rate on unsecured debt. That said, their sizable market capitalization, strong Adjusted ROA profile, and substantial cash generation would likely allow them access to credit markets to facilitate debt refinancing if necessary.
Like most people, senior executives and board members do what they are paid to do. This is why AGN's Form DEF 14A is key to understanding this company's fundamentals, something that credit agencies seem to be missing. Our Incentives Dictate Behavior™ analysis focuses on AGN's senior executive compensation and governance. This analysis is meant to help investors understand corporate governance, how aligned a management team may be with shareholder interests, and the potential consequences of a management compensation framework to the business.
AGN's short-term compensation is based on non-GAAP EPS and individual performance goals, while their long-term compensation is granted through performance share units (PSUs) and stock options. The PSUs are solely based on TSR compound annual growth rate (CAGR).
The non-GAAP EPS metric would likely drive management to focus solely on growth and margin expansion, to the potential detriment of the firm's asset turnover ratio. That said, given their historical success in driving ROA' growth through margin expansion, this risk is likely muted. However, management may be biased to allocate excess cash flows to share buybacks rather than for servicing debt obligations, heightening credit risk.
We provide analyses of companies' statements on earnings calls, termed Earnings Call Forensics. This analysis is meant to help assess a management team's confidence in their conference calls when discussing certain areas of the business such as operations, stability, strategies, their ability to manage business risks, and especially, their liquidity and solvency.
In the case of AGN, the analysis of their Q4 2015 earnings call highlighted mixed markers from management. Management appears confident when saying that they have an innovative R&D pipeline sourced from strong internal science and 'Open Science' to fuel future growth. They also appear confident when saying that they will push the FDA to make sure they are correctly evaluating their products. On the other hand, they appear to be downplaying concerns about price erosions in their markets, and may be concerned about their ability to effectively pay down their debt following the divestiture of their Generics business.
Ultimately, a company's credit risk (or lack thereof) is driven by cash available against cash obligations. AGN's credit risk is being overstated by Moody's and cash bond markets. Given AGN's strong cash flows relative to all obligations including debt maturities, healthy liquidity profile, and sizable market capitalization, ratings are expected to improve while cash bond market spreads are expected to tighten once the company's fundamentals are recognized.
Our Chief Investment Strategist, Joel Litman, chairs the Valens Equities and Credit Research Committees, which are responsible for this article along with the lead analyst, Cheska Pablico. Professor Litman is regarded around the world for his expertise in forensic accounting and "forensic fundamental" analysis, particularly in corporate performance and valuation.
Disclosure: I am/we are long AGN.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Officers of Valens Securities and Valens Credit are engaged and have beneficial interest in an investment management company, Kennebec River Capital, which has positions in Allergan plc (AGN) as of the date of this report.