The following segment was excerpted from this fund letter.
Last fall I converted our equity investment in Allergan (NYSE:AGN) into long-term call options expiring in 2021 with strike prices between $125 and $150 for reasons I covered in the prior letter. At the end of last December when the stock fell to even more unreasonable levels, I increased our investment by buying Allergan's equity at $130. During Q2 2019 the stock fell again, and I re-assessed the investment thesis from scratch and lowered some of my base case assumptions for long-term market share for Botox. The result was to lower my base case from over $250/share to $227/share.
As the stock was trading close to 50% of my revised base case value estimate, I added to our investment, first at $125 and then again at $117. When I made the latter purchase, in June, one of the market's concerns was opioid litigation, and the risk of any liability that Allergan might have. Allergan has sold its generics business to Teva (NYSE:TEVA), and the latter had indemnified the company against any liability. However, Teva's balance sheet is very weak, and it is possible that in an adverse litigation outcome, the company could go bankrupt (its Credit Default Swaps, CDS, spiked significantly once the litigation issue arose). I believed that any liability to Allergan for opioid litigation was very unlikely, but it is also outside of my circle of competence to properly judge such complex legal issues. So as I was making the investment a large position, I decided that I wanted to hedge against this risk to protect us against low-probability large permanent capital loss. I did this by buying 2021 put options on Teva with a strike price of $3. The logic was that for Allergan to face liability, Teva would need to go bankrupt first, and Teva's stock would go close to zero in such an event.
As an aside, I want to highlight how behaviorally difficult it was to keep adding to the Allergan position as the stock was going down. Even the best investors are not robots, and as a large position gets marked lower and lower by the market, it is only human for doubts to begin to creep in to one's thinking. However, that is the whole point of my rigorous investment process. Regardless of what I might be feeling, the point is to act fully rationally based on a continuous comparison of price and value. I didn't feel wonderfully adding to the investment, but because of my investment process I knew it was the right thing to do and acted accordingly. When I tell people that my temperament is part of my competitive advantage as an investor, it is frequently hard to demonstrate. I would argue that this is an example of that temperament in action.
Shortly after my last purchase of Allergan stock, AbbVie (NYSE:ABBV) made a cash and stock offer for the company. The terms for each share of AGN were $120 in cash and 0.866 shares in ABBV. AbbVie's management believes that it can generate $2B per year in cost synergies by year 3 after the deal close. I estimated the stand-alone value of ABBV to be around $65 and the post-deal value of ABBV to be in the high $90s. At the current market price of $69 for ABBV shares, AGN shareholders are due to receive value of ~ $180. At my post-deal intrinsic value estimate of ABBV shares, we would be receiving ~$205. Both of these are below my $227 base case estimate for AGN, so while I am glad that the timing to the price to value gap closing has been pulled forward, I am mildly disappointed that we didn't get a price that more fully reflects the standalone value of the business, much less the value of synergies of the two companies.
As an interesting aside, the CEO of Allergan stood to make $30M following a change in control, and he was able to get a Board seat on the combined company. He owned approximately $30M in stock. I will leave it to you to decide if negotiating vigorously for another 10%-20% in price would have been worth it if it meant jeopardizing the deal from the perspective of his self-interest.
At this point, I decided to keep our entire investment in Allergan as is. There are three possibilities:
- The deal breaks because of some exogenous factor (e.g. China decides to use this as a bargaining chip in the trade war, Trump decides to use this as a bargaining chip to get drug price concessions as part of his re-election bid, etc.). There are no legitimate anti-trust concerns to speak of. In this scenario, while the stock is likely to go down in the short-term, I am happy for us to own deeply undervalued Allergan and let my thesis prove out in the public market.
- The deal goes through as is. Assuming a close in 9 months the IRR to the deal value using ABBV's market price is ~ 12%, which is a fine return considering the low risk. Further, the IRR using ABBV's intrinsic value post-deal is much higher.
- There is a second bid. I believe the possibility is small, but not zero. Allergan has valuable, unique assets that many should want. AbbVie does not have a particularly good strategic fit with Allergan. It is just trying to offset the revenue declines that will be caused in a few years by some of its major drugs going off patent. There are other large pharma companies in a similar predicament, so I do believe that a higher bid is possible.
Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.