After A Sharp Pullback, Is Allergan Pretty Enough?

With its very strong (and lucrative) positions in markets like aesthetics (including the well-known Botox), eye care, device-based plastic surgery, Allergan (NYSE:AGN) arguably merits the premium valuation it typically gets from the Street. Recent developments pertaining to generic competition to Restasis has shaken investor confidence, though, and sent the shares down more than 20% to today's level. Although I do believe that bears may be overestimating the threats to key franchises like Botox and Restasis, it is hard to make a confident call that Allergan is dramatically undervalued now, other than to say that the Street has often been willing to overpay for these shares and may again in the future.

The Current Business Is Still Pretty Good
With almost all of the worries around Allergan involving what may be, it's worth noting that the business is doing pretty well in the here and now.

Revenue rose 7% from last year, a bit above the average expectation. Growth was fueled by the drug business, as pharmaceutical sales rose 11%, while device revenue rose 7%. Within drugs, Botox and Restasis both continue to grow at double-digit rates, while both the breast and facial devices segments saw double-digit sequential growth as the aesthetics procedures market improves.

Allergan likewise did pretty well below the top line. Gross margin improved about a point, and was better than the sell-side expected. Although Allergan did give some of that back through higher R&D spending (up 17%), operating income still rose 12% and operating margin was about a half-point better than last year (and in-line with expectation).

Multiple Challenges To Lucrative Franchises On The Horizon
There are definitely clouds on Allergan's horizon, and the extent to which the company can navigate the impending challenges will go a long way towards solving Allergan's future revenue growth rate and margin structure.

On Botox, Allergan continues to expand the usage in migraine and overactive bladder, even though the reimbursement for OAB isn't always that strong. But while this should be a growing $2 billion business this year, competition from Merz's Xeomin and Johnson & Johnson's (NYSE: JNJ) PurTox could challenge the business. Looking back a bit into the past, Allergan did absorb the introduction of Medicis' (now Valeant (NYSE: VRX)) rival compound Dysport, but it did lead to meaningful reductions in effective price.

The bigger near-term risk to the story comes from potential genetic competition to Restasis, the only FDA-approved dry eye medication. The FDA has laid out a path for approval that could exclude the need for human trials, and though the formulation of an approvable generic version will be challenging, there are numerous companies with the capability of doing so (including Novartis (NYSE: NVS), a major eye care company). The bullish case would be that Restasis generics take longer to get to market than expected, and/or that pipeline candidates like Restasis X can bridge the threat, but the bears are worried that Allergan is facing the near-term loss of meaningful high-margin revenue.

As an aside, it's also worth noting that Johnson & Johnson and Valeant have formed an alliance to work together in the aesthetics space. In broad strokes, this alliance will reward physicians for prescribing/using products from either company, essentially neutralizing the loyalty and volume benefits that Allergan can offer due to its wider range of products for the aesthetics market.

Last and not least is the pipeline. The trouble for Allergan is that most of the high-potential products are a ways back, while the products closer to market seem less likely to generate strong revenue. Levadex, the troubled migraine drug that Allergan acquired with the MAP deal, should get approval by year-end and though I was once bullish on this drug, the current sentiment is that Allergan will be lucky to generate more than $300 million in sales (though management believes it's a $500M-plus drug). Elsewhere, orzurdex is likely to be a modest revenue contributor, while the anti-VEGF DARPin drug for wet AMD isn't likely to see a launch before 2017.

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The Bottom Line
By and large, betting against Allergan for any sustained period of time (and/or failing to buy on significant pullbacks) has been a mistake. Along those lines, it's well worth noting that Allergan may fend off rivals in Botox and generic Restasis better than feared, and that Allergan's significant marketing muscle in the migraine space (where it has been able to successfully market an injected paralytic agent) could spell better things for Levadex.

Today's valuation seems to factor in about 7% long-term free cash flow growth (with approximately 5% underlying revenue growth in my model). Taking a more bullish view (one that includes $500 million in Levadex sales in 2018, as well as success with DARPin and brimonodine, and modest Botox and Restasis pressure), I think free cash flow growth of around 9% and a fair value of $98.50 is a reasonable bullish outlook. With that, Allergan isn't exactly shockingly cheap, but this is a company with multiple valuable franchises, a good marketing team, and potential takeover value to a growth-starved pharma space.

Disclosure – At the time of writing, the author had no position in any companies mentioned.