What's Ailing Allergan's Share Price

| About: Allergan plc (AGN)

Summary

We offer four reasons for Allergan's underperforming share price.

Survey of PE ratios and forecasted growth rates for top US pharmaceutical companies and Allergan.

Allergan's share price should recover if the company continues to execute operationally.

As value investors we're often looking for bargains in the dustbin. We sift through the discards and unloved, stocks that Mr. Market has decided is out of favor, in search of the "hidden treasure." We try and focus on the fundamentals, examining the company's current slate of products, what the pipeline looks like, and what the strategy going forward will be.

Once we acquire a company, we will sometimes write articles about the investment to see if we can generate some contrarian viewpoints to test our investment thesis, and with Allergan it's no different. In the case of Allergan (NYSE:AGN), however, the two most common questions we overwhelmingly receive is "why is the stock so low and when will it recover?"

We rarely respond though because timing is always tricky. We believe if the management team and employees continue to execute operationally, then the underlying fundamentals will improve and the share price will eventually recover. Stated simply, we believe favorable corporate earnings ultimately drive a company's value, and in turn its share price.

We know though that it's not always that simple. External factors like the election year, shareholder turnover and a change in the investment thesis means a company like Allergan can suddenly be out-of-fashion. We think there's a few reasons why Allergan in particular is currently trading at a 52 week low (as we write this, Allergan closed at $227.55, down approximately 26% YTD):

1. Shareholder turnover:

a. Former legacy-Allergan shareholders have sold the shares after Actavis acquired legacy-Allergan in 2015;

b. Former legacy-Actavis shareholders have also exited as the Allergan today is a very different company in its current incarnation than the fast-growing, debt fueled, Actavis of prior years;

c. Merger arbitrageurs exiting: traders exited Allergan after the Pfizer/Allergan deal fell through in 2016;

d. Institutional holders: dividend mutual funds that historically owned legacy-Allergan no longer own the stock because new-Allergan no longer pays dividends, shrinking the pool of potential investors;

2. Drug pricing: presidential candidates have called for more regulations to control drug prices, which may weigh on future earnings and dampen enthusiasm for pharmaceutical stocks; the IHE, an ETF which tracks the Dow Jones Pharmaceutical Index (an index of US pharmaceuticals companies based on market capitalization) is down approximately 11.7% YTD (Jan. 1 to Oct. 14);

3. Wait-and-See: investors waiting for Allergan to execute operationally as previous growth came mostly from a "roll-up/M&A/inversion" growth strategy (Allergan's current management team has yet to show that they can grow materially without large acquisitions);

4. Issued US tax regulations limit the scope of both acquirors and targets for Allergan, which simultaneously reduces the likelihood of a buyout (i.e., and in turn removes any takeover premium) and its ability to acquire other companies to expand.

Allergan and Its Peers

The company has recently undergone some turmoil. After a series of its own acquisitions, Allergan agreed last year to sell itself to Pfizer, a US based pharmaceutical company. This merger proved controversial because it would mean Pfizer could effectively redomicile to Ireland, which would reduce its future US tax liabilities. The US government subsequently issued and proposed new tax regulations that would detrimentally impact the combined company. Consequently, the parties agreed earlier this year to abandon the acquisition and Allergan's share price fell from $307 per share at the beginning of the year to $227 per share today.

We believe Allergan is undervalued for many reasons, which we've detailed here and here, and the company has excellent prospects going forward (e.g., its ability to generate cash is excellent, underappreciated pipeline, CEO is a phenomenal capital allocator, etc.). We've held this thesis for a bit, and although the market currently disagrees with us, eventually the sentiment should change as the company successfully executes against its plan. How undervalued? Let's just look at two metrics, PE and Revenue Growth for Allergan and its peers.

Reviewing PE

Below is a chart showing six of the major pharmaceutical companies in the US and their PE ratios for 2017.

PE

Rev CAGR

EPS CAGR

2017

16-'21 (%)

16-'21 (%)

ALLERGAN (CS EST)

14

8%

14%

MAJOR PHARMA (US)

AbbVie (NYSE:ABBV)

13

5%

8%

Bristol Myers (NYSE:BMY)

20

4%

10%

Eli Lilly (NYSE:LLY)

19

6%

17%

Johnson & Johnson (NYSE:JNJ)

16

3%

4%

Merck & Co (NYSE:MRK)

15

5%

11%

Pfizer (NYSE:PFE)

13

3%

6%

Average

16

Click to enlarge

Credit Suisse (2016 09)

If we looked at price earnings multiples ("PE" ratios) and EPS growth rates we can easily see the disparity. Although there are many issues with price-to-earnings ratios ("PE" ratios) (e.g., management's ability to manipulate GAAP accounting, ratio does not reflect true cash generating factors, etc.), they are useful here to illustrate a point. In the above snapshot, we can see that Allergan is forecasted to grow earnings per share by 14% per year from 2016 to 2021. This potential growth rate is the second highest growth rate among the 6 major pharmaceutical companies in the US, second only to Eli Lily's 17% growth rate.

Although Allergan has a higher forecasted growth rate, 40% faster than Bristol Myers ("BMY") (i.e., 14% vs. 10% for BMY), or 250% faster than Johnson & Johnson ("JNJ") (i.e., 14% vs. 4% for JNJ), it is still valued at 30% and 13% less than BMY and JNJ, respectively (AGN PE ratio of 14 vs. 20 for BMY and 16 for JNJ).

Reviewing Revenue Growth

That's earnings (well a version of it), but let's take a look at revenues since EPS can easily be "managed", particularly on a one-year basis. Here Allergan is again forecasted to be the peer group leader. Revenues are expected to climb 8% per year, 33% better than Eli Lilly ("LLY") at 6% and double that of BMY.

Yet for all of this (i.e., having the highest forecasted sales growth and close-to-highest forecasted growth in EPS), the company continues to lag on a near-term PE basis, not only to the high performers like BMY and LLY, but to the average pharmaceutical company in the US.

In totality, these numbers tell us that Allergan's revenues and earnings growth will place it at or near the top of six major US pharmaceutical companies, but the stock price today trades at a 13% discount to the average of these companies. Said another way, the market views Allergan as a below average pharmaceutical company, when in fact, it's quite the opposite. If Allergan's shares were to trade at the same +19 PE multiple as BMY or LLY, the shares would exceed $300.

In the end, we think this discrepancy will be temporary if Allergan can execute operationally and hit the forecasted numbers above. Do that, and Allergan's valuation gap will take care of itself. A company that compounds earnings 40% faster than the highest valued company, will eventually attract attention from capital allocators because every invested dollar in Allergan will vastly outperform its peers. The market is after all fairly efficient in the long-run.

Others factors depressing the stock, such as the election year rhetoric on controlling drug prices, will fade in time. Stump speeches typically sound worse than the actual regulatory bite. It's important to remember that this is currently a headwind for all pharmaceutical companies, and not just Allergan. Given its size and name recognition, Allergan is unlikely to escape unscathed when the pharmaceutical sector is down 11% (i.e., YTD return of IHE), so for the time being this factor will still dampen enthusiasm for pharmaceutical stocks in general.

For all of these challenges though, we think confidence in the company will rise and the shares will rerate if Allergan can deliver solid earnings growth in the next few quarters. Amidst the noise, earnings will have to shine through to attract new investors. We continue to believe fair value is closer to $335 per share, approximately 50% higher than today's closing price.

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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.