A Slow Clap For Allergan, But Hold The Applause... For Now

| About: Allergan plc (AGN)

Summary

Initial impressions on Allergan's multiple.

Management beginning to repair credibility.

Investor sentiment continues to improve and should as 2017 unfolds.

Reestablishing credibility. That's what Allergan's (NYSE:AGN) fourth quarter earnings were about. Meeting earnings expectations and raising guidance slightly was the first step in restoring management's credibility and investor sentiment in Allergan's stock after the Q3 fallout.

Beyond affecting short-term investor performance, why is this so important for the company? Well for an acquisitive company like Allergan, it could potentially raise the cost of capital if it ever plans to use Allergan stock in a large acquisition. Let's explain.

Cost of Capital

There are typically four sources of cash to fund a growing company like Allergan: cash on hand, cash from current earning, derived from stock sales and/or borrowings. The latter two relies heavily on credibility. What do we mean by this? Well let's take debt for instance. As an individual, when you borrow, your cost of borrowing (i.e., interest rate) depends heavily on your FICO score, which is essentially your ability and willingness to repay debt distilled into a single number (i.e., your level of credibility based on your history with debt). For companies, their "FICO score" comes in the form of a rating from one of the ratings agencies (e.g., Moody's, S&P, etc.) on the bonds they issue. This rating similarly reflects in part management's credibility (i.e., the likelihood management and business can deliver on its forecasted earnings/cash flow to service the debt).

For stocks, this sentiment is expressed differently, but expressed nonetheless. A great business with an unreliable management team would never yield a premium on its stock, and if you're planning to grow the company via acquisitions, and the currency you plan to use is stock (i.e., exchange your stock for a target's stock), a lack of credibility essentially reduces the value of the currency you plan to use, thereby raising your cost of capital.

Take Allergan for instance, it projects non-GAAP earnings to land between $15.80 - $16.30/share for 2017. The stock currently trades at $244/share. If we use a mid-point of $16/share in earnings, investors today are willing to pay 15.3x for every dollar of earnings in 2017. Not bad, but that's what the pharma sector is currently trading at. Yet if Allergan is growing its bottom-line by 17-21% (2-3x its peers), shouldn't it garner a premium valuation? You'd assume so, but darn . . . there it is again, credibility. Thus, if Allergan plans to conduct a large acquisition, it likely will have to use its depressed stock (given its $10B in cash on hand and $33B in debt), which means having to pony up more shares in an acquisition and raising its cost of capital. So you see, just as low credibility means having to pay higher interest rates for debts, low credibility means having to exchange more stock when your stock price is depressed.

Could it Rise?

Many investors have asked whether we think the stock can continue its climb, and potentially hit $300/share. What we've said is that either earnings have to rise materially (i.e., above $16/share) and/or the sentiment on the company has to increase (i.e., instead of paying 15.3x people will willingly pay 17 to 20x). The latter is more likely than the former because remember, this is a business. It's difficult to increase sales dramatically when you're base is $15.5B; easier to decrease expenses, but under investing in marketing, G&A, or R&D comes at a potential price.

Moreover, sentiment can rise or fall far faster than fundamentals, remember just a month ago Allergan was trading around $190/share, which carried with it a multiple of 12x.

Stock Price

2017 Earnings

Multiple

% Gain on Multiple

$190.00

16

11.9

$244.00

16

15.3

28%

$272.00

16

17.0

11%

$304.00

16

19.0

12%

The recent rise can be explained by three things:

1. January 5 - Brent Saunders announces that Allergan's 2017 guidance will be more conservative, mitigating the risk that the company fails to meet aggressive earning targets and repeat the Q3 earnings experience.

2. January 31 - President Trump's meeting with pharma industry executives is generally viewed as positive. The potential for reduced regulations, tax reform and the reduced threat that the administration will push to allow government agencies to negotiate drug prices directly boosts the sentiment surrounding the pharma/biotech sector.

3. February 8 - Allergan's earnings release. Viewed as a "beat and raise".

So coming off of the lows in December, Allergan's share price has recovered some of its luster, trading at least in line with its peers. Allergan still trades at a substantial discount to what a company with similar earnings growth would typically warrant, but forecasts are forecasts. Delivering and executing on the forecasts are what counts. Can Allergan again trade at a premium to its peers? We believe it can. Having said that, does it deserve to? Not quite yet because that's sentiment folks, and sentiment follows credibility.

In our missive dated January 6, following Allergan's announcement to guide more conservatively going forward we stated

"Allergan has set-up an achievable hurdle and we think the company will be able to clear it. 2017 can be the year where management reestablishes its credibility, and with a few quarterly "beats", Allergan's multiple could rise again. For now, we think the stock's weakness at the end of 2016 and recent strength coming into the new year was largely the abation of tax loss selling and investors again repositioning into the stock. For now we're leaving our price target the same at $240-$270/share, but could raise it once a few "beats" are in hand."

We think this continues to be true, and it's playing out now. It takes time to rebuild credibility, but management appears to have learned a valuable lesson. We're not applauding management quite yet, maybe just a slow clap for now.

We have a few more thoughts on the quarter and going forward, which we'll address in another post so check back with us in a bit.

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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.

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