I'm bullish on AbbVie (ABBV). It remains one of my largest pharma stocks, and I'm willing to add more, should the opportunity present itself. And I believe that it now has, and may even improve going forward.
In this article, we'll take an updated look at the proposed acquisition of Allergan (AGN), and why I believe that such a M&A would create a stronger company and, more importantly, a stronger AbbVie less reliant on current products.
Even with a potential debt increase, I believe AbbVie at this price presents a compelling valuation and opportunity - and I've increased my position.
A potential M&A to solve some of AbbVie's problems.
So, in my original article titled "AbbVie: Not A Swan, But A Steal At Its Current Price", I argued that one should invest in the company only if one understood the risks involved. As a spin-off that's less than 10 years old, it has some convincing pros but some significant risks as well.
The biggest problem/risk with AbbVie is still its absolute overreliance on the drug Humira. You don't get to run a successful company with ~70% of profits from one medication slated to lose exclusivity in 2023 and be called a SWAN/safe investment. That is still the case - especially since the company isn't very international in terms of its sale compared to other pharmaceutical companies.
Prior to the proposal, AbbVie has a good debt ratio, at roughly 2.15X to EBITDA. M&As aren't exactly uncommon for AbbVie either - the company has bought Pharmacyclics, Stemcentrx, and others. As I wrote in my previous article, AbbVie has made both good M&As as well as bad ones.
Now, the company has never had a M&A of this size. The proposal would involve a massive €63 billion cash amount. The amount at the time of the proposed M&A was roughly 45% over the going share price. As a result of this, AbbVie stock price took a definite hit, which is part of the reason why I'm writing this article - to gauge whether this is a fair reaction or not.
For those interested in AbbVie basics, I refer you to my last article. These pre-proposal fundamentals haven't changed all that much. Here, we'll focus on forwarding potential.
(Source: AbbVie Slideshow - Seeking Alpha)
First of all, this move can definitely be characterized as a defensive one. While the company would like us to focus on the opportunities and growth potential, I'll focus on the risk reduction found in this potential deal that would reduce the overall impact of Humira sales. This is the core - the question is, will this reduction of risk be purchased at an appealing price point?
(Source: AbbVie Slideshow - Seeking Alpha)
There is no doubt that the new company would represent a very strong player in the pharma market, coming in behind only the largest companies in the global market.
AbbVie expects the new potential company to rely less than 40% on the sales of Humira. This is still quite a bit; the risk is still there, but it has been significantly reduced.
The company also makes some impressive promises in conjunction with this proposal.
(Source: AbbVie Slideshow - Seeking Alpha)
Those of us who remember AbbVie's less-than-positive deals know well the risk-taking in a M&A where synergies fail to materialize due to one reason or another.
Because one of the targeted products in this proposal, Botox, is already widely available and used, however, these risks aren't that relevant to this potential offer. The acquiring of Allergan and its products (including Botox), as such, is meant to stabilize the company's revenue stream both until 2023 and beyond, enabling AbbVie to use Humira sales in order to pay down the acquired debt, should this transaction go through.
In addition, Allergan has more than just Botox. Let's review the company in question.
Allergan - Quick review
Founded in the 1950s, Allergan acquires, researches, develops and markets brand-name drugs. It sells mostly to the U.S Healthcare system, and AbbVie's offer for the company isn't the only one it's gotten (more on that later).
The company has revenues of ~$15 billion annually and employs almost 18000 people worldwide.
Its portfolio includes:
- Botox, which can be used both for cosmetic and medical purposes.
- Memantine, the 147th most prescribed medication in the US (4 million prescriptions), a treatment against Alzheimer's.
- Restasis, with 2 million prescriptions in the US, eye drops used to increase tear production.
- Linzess, a medication against IBS and constipation.
- Bystolic, a beta-blocker with 5 million prescriptions in the US.
- Juvederm, a popular injectable filler.
- Latisse, a medication used to treat high eye pressure, with about 1 million prescriptions.
- Teflaro, a successful antibiotic.
- Dalvance, another successful antibiotic...
... and many more. Allergan is active in the areas of aesthetics/plastic surgery, CNS, eye care, women's health and urology, cardiovascular diseases, infectious diseases, cystic fibrosis, and gastrointestinal diagnoses.
In short, what AbbVie is proposing to buy here is not a company that depends on a singular drug, which eventually may fail (such as Rova-T). This is the suggested M&A with a company that has strong names - one might suggest some as strong as Humira, or close to it. Allergan is an appealing company, one which I often have looked at for investment as well.
So far, so good.
Why the negative market reaction?
As a reaction to the news, AbbVie stock dropped quite a bit. The market did not like the proposal. The stock has recovered since then, and is currently trading at roughly 8.55X forward earnings - which, by the way, is still cheap from a historical and fundamental valuation perspective in relation to forward, expected earnings.
Well, most important of all, the debt that AbbVie needs to take on in order to push this through is no small feat. As of 1Q19, it has about $6.7 billion on hand, and it already has a current net debt load of roughly ~$30 billion. The company is now looking to extend this to bring the total debt load up to ~$92 billion in net debt. Not only will this increase the company's indebtedness, but it will also most certainly increase the interest expense - and this during a time of potential market volatility going forward. In addition, Allergan has, during the past few years, not exactly been stellar in terms of meeting its own guidance and goals.
So, the market, I believe, sees the leverage as something to be concerned about and the suggested company not to be as blue-chip as one would like - and I do agree to some extent here. Let me clarify somewhat.
I bought AbbVie knowing fully well the company's reliance on Humira, as well as the forward risk. My article saying that AbbVie wasn't a SWAN is certainly still true to my mind. However, in doing what AbbVie is now doing, it is targeting my main worry with this investment. The Humira reliance will be lowered, even if Botox/Humira combined will represent a large portion of sales for the potential new company.
Thus, insofar as reducing dependence, the deal appeals.
At current company guidance, the combined earnings will be roughly ~$18.5 billion prior to the additional interest expense incurred as a result of the new debt (~8.8/share EPS for AbbVie, ~16.55/share for Allergan). Combining the share count of these companies and accounting for the M&A terms, we get a combined EPS of ~$9.5-9.9/share - and this is before synergies. The quick math here seems to make sense, at least on the surface.
Once again, the deal appeals here.
In terms of forward risk for each company, we see similarities between AbbVie and Allergan. Both companies face a loss of exclusivity (LoE) in the coming years. AbbVie through the loss in Humira in 2023 in the US (and already lost it in Europe), and Allergan through a whole host of LoE losses beginning in 2018 and going all the way through 2023. The most significant of these are Restasis, where the company will lose over $1.1 billion in annual revenue, losing exclusivity in 2019, and Bystolic in 2021. Bystolic - a high blood pressure medication - represents another ~$580 million in sales.
I knew when investing in AbbVie that the company would eventually have to find some way to reduce its dependence on Humira. I did not expect it to come in the shape of this proposal, though I did expect some M&A action.
The reason I don't view the proposal as negative (and why I remain an AbbVie bull) is that I believe AbbVie is actually paying a good price for Allergan. We know that the pharma/healthcare sector is out of favor with the general market at the moment, which has resulted in some pretty depressed valuations for many companies, including Allergan.
I view the price from a historical perspective. Allergan has actually, as I mentioned earlier, been on the block before. Pfizer (PFE) was interested in purchasing the company - and Pfizer's bid at the time came in at a whopping $363.63/share back in the day. Comparing this price to the current one that AbbVie may pay, the question may be: Do you believe that Allergan has lost ~50% of its market value during the last 3-4 years (if you believe the offer back then was made at a somewhat decent valuation)? I, quite obviously, don't think so. There's more to the valuation than that - but the point is that I don't view a 45% premium to a depressed share price as a bad deal, even considering some of Allergan LoEs we're seeing until 2023.
The core question comes down to: What is AbbVie paying, and what is the end result?
As a result of an M&A, AbbVie would:
- Reduce dependence on Humira, and add Botox as well as several impressive medications to its lineup.
- Further expand already existing women's health and gastroenterology product lines, adding new positions within Medical Aesthetics/Plastic Surgery as well as Neuroscience.
- Form the new, combined company into the two parts of the "Growth platform", responsible for the investment and developing new, while using existing leadership positions to drive acceptable revenue growth over the next 10 years, as well as the Humira portion, which would act as the cash cow in order to pay down the debt incurred in this transaction.
- Become a far larger competitor with the financial and company-related muscle to take on investments and market challenges.
- Buy Allergan at a very depressed share price and discount compared to the past offer of 2015.
However, through this M&A, AbbVie would also:
- Take on an excessive amount of debt, increasing leverage to, at the very least, a 4X or above in relation to EBITDA.
- Acquire a company that, during the past years, has performed not all that great in addition to losing exclusivity to several key drugs over the next few years.
- Subscribe to a strategy that, for some corporations in Europe, hasn't exactly worked well. It's not always a solution to simply "buy" an asset/company and staple it onto a different company in order to solve a structural/reliance-related issue.
- Issue new stock at a stock price significantly below some of its buyback prices - above $100 - as well as taking on debt/leverage at a depressed company share price, which is always less than ideal.
As you can see above, the case can be made for both a bull and a bear thesis on this pharma company as a result of this deal. The key seems to be: Can management execute on the promised synergies, debt reduction, and capitalize on the growth opportunities presented here?
If they can't, you'd look at a company losing patent protection across the board in 4 years without meaningful replacements for many products. The share price would likely follow this losing trend, and sooner or later, the company would have to cut its impressive dividend.
If they can, this marks a very appealing entry or opportunity to add more shares.
(Source: F.A.S.T Graphs)
Other contributors focus on the double-digit returns achieved at market valuation in case AbbVie returns to normal P/E valuation. Because of the risk involved, I use the historical discount and assume the absolute worst - that AbbVie continues falling.
As we can see in this case, even at further discounted valuations, provided the company does not cut or meaningfully impact its growth rate, you will not be losing money in this investment as long as things move somewhat in a positive direction.
We can also mention that this company very rarely misses estimates by a great margin, or the fact that if AbbVie does return to a somewhat normal valuation, you'd be raking in annual returns of almost 30% including dividends - and this is not something I consider unlikely.
My thesis on AbbVie has been, and remains, one centered around the firm understanding of risks. The risk you've taken before is that management needs to find a meaningful replacement for its Humira dependence post 2023.
Now, management has come out and said: "Here's our solution - let's buy Allergan!"
To me, this becomes a classic value exercise, where we can look at something as basic as company management. Just as management was a reason for me trusting the company enough to invest months back, so too is management at this time a reason for me to believe that they can:
- De-leverage quickly enough to solve the debt issue prior to LoE for Humira/other medications.
- Capitalize on growth opportunities and synergies.
Because if the company and management are unable to do this, the debt, the purchase price - none of it will really matter in the face of the headwinds.
CEO Rich Gonzales and other management is where I, in this case, put a great deal of trust. Because of his tenure as president of Abbot Laboratories (ABT) and being CEO of AbbVie since 2011, his experience here is second to few. His hand-picking to the role of CEO is another point in his favor, as are the impressive results he, and other management, has led the company to.
Don't get me wrong. Management alone isn't enough. AbbVie is an appealing company at an attractive price, as we can see above in the valuation portion. These depressed valuations, in my opinion, take into consideration that AbbVie fails to achieve synergies and capitalize on growth opportunities.
I disagree with the negatives here. AbbVie's track record speaks for itself - and I believe the company will, in the future, once again show us that it can excel in an incredibly competitive field.
That is why, following this proposed M&A, I remain an AbbVie bull and have extended my position somewhat.
As of this article, I consider AbbVie a "Buy" at these levels of ~$75/share. I myself have increased exposure to the company slightly. I do think investors should size positions accordingly and with respect to their own risk tolerance.
I will update this article or publish an updated thesis should things change, and/or in conjunction with future earnings updates.
Disclosure: I am/we are long ABBV. 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: While this article may sound like financial advice, please observe that the author is not a CFA or in any way licensed to give financial advice. It may be structured as such, but it is not financial advice. Investors are required and expected to do their own due diligence and research prior to any investment.