9/23/19

Abbvie Part II: Buy ABBV for a Multi-Year 30%+ Compounder

“As a general thing, I’ve always been drawn to characters who appear to be one thing on the surface, but are actually something else underneath.” – Michael Sheen
Comparable Company Analysis 9/23/19

Summary Background on Abbvie

Abbvie was spun-out by Abbott Laboratories about seven years ago and is the former biopharmaceutical division of that 130-year-old company. What Abbvie is now is one of the leading biopharmaceutical companies in the world with over $30bn in annual revenues which is poised to grow to about $50bn of annual revenues upon the closing of the Allergan acquisition. Abbvie’s current business is comprised of therapies in four main categories: Immunology/Inflammation (60% of sales – virtually all from blockbuster Humira), Blood Cancers (15% of revenues), Infectious Disease (9% of revenues – all HCV related) and Other (15% of revenues). Abbvie’s position in Immunology/Inflammation cannot be understated. Worldwide inflammation revenues were >$50 billion (>$35BN US) and that therapeutic category is growing at a rate of low to mid-teens (per UBS research). Abbvie’s revenues in that category are ~40% of worldwide revenues in the category.

Abbvie has been “crushing it” in term of financial and operating performance for the past five years when comparing results to peers. Amongst the peer group highlighted below, Abbvie was #2 in terms of revenue growth over the last five years and a distant #1 in terms of EPS growth. On a projected basis pro forma for the Allergan acquisition, Abbvie’s also forecast to deliver the second-best EPS growth of any in its mega cap biopharma peer group – only behind #1 Bristol-Myers Squibb.
So, with all this superior historical and forecast financial performance, why is Abbvie trading so cheap? What gives?

“Characters that appear to be one thing”

As discussed in Part I of this report, Abbvie has an 800lb guerrilla in the room in terms of its exposure to Humira – the largest drug by sales in the world which is an injectable (large molecule) drug that’s primarily used to treat rheumatoid arthritis (RA) and plaque psoriasis. Humira is a drug that:

a)  Is currently 59% of Abbvie’s revenues
b)  Lost European patent exclusivity last year and started facing biosimilar

competition in that region in October 2018
c)  Faces biosimilar competition in the U.S. come January 31, 2023
Given such enormous exposure to just one drug with limited additional runway before, likely, punishing biosimilar competition, many investors put their pencils down after only a cursory look at Abbvie and maybe put a reminder in their calendar to check back in mid-2023 to see how things have developed. I submit that that approach to Abbvie creates a compelling opportunity for the more diligent investor.

The challenge for big/mega pharma when it becomes overly exposed to a mega- blockbuster drug ($5bn+ of annual sales) is how does that pharma company overcome the challenge when that drug loses patent exclusivity. Historically, there are plenty of examples of when XYZ big pharma wasn’t able to come up with a next generation drug sufficiently addressing the same category(s) and thereby went through a wrenching decline in that category(s) revenues. Notable examples include Pfizer’s experience when it lost exclusivity for Lipitor, Bristol-Myers with Plavix, AstraZeneca with Nexium and Eli Lilly with Zyprexa.

What makes the situation around Abbvie and Humira interesting is Abbvie appears to have two recently (2019) approved drugs, Skyrizi (for plaque psoriasis) and RINVOQ (for rheumatoid arthritis), that are arguably superior to Humira in their targeted indications and RINVOQ benefits from being an oral, small molecule drug (not large molecule injectable drugs like Humira). Most people would much prefer to take a medicine orally than via an injection (Skyrizi is an injected biologic).

The above cropped slide is taken from Abbvie’s 2017 strategic update and highlights the anticipated overlap of Upadacitinib (RINVOQ – just FDA approved in August), Skyrizi (Risankizumab approved in Q2) and Humira. For RINVOQ, Abbvie management is on record predicting sales of $6.5 billion by 2025 (and that prediction was made two years ago – I submit that forecast may now be higher). For Skyrizi, Abbvie is forecasting $5bn in sales by 2025 (same being true for Skyrizi where these forecasts are two years old and are likely to be going higher). What’s particularly encouraging for Skyrizi is that the drug is having a very strong launch right out of the gate and appears to be on early trajectory to materially beat expectations.

Between Skyrizi and Humira Abbvie is winning “almost 50%” of “in-play patients” with about half the wins coming from Skyrizi. Abbvie took a $2.3bn charge in Q2 2019 due to the increase in the estimated fair value of future royalty and milestone payments associated with Skyrizi.

While things are early in, the analyst community is “abuzz” about the launch of Skyrizi. As highlighted above, Skyrizi did more sales in its 1st two months of sales than Otezla (the current market leading oral psoriasis drug) did in its 3rd full quarter of sales back in 2014. As those who have been following the Bristol-Celgene situation are aware, those companies just decided to sell Otezla to Amgen for $13.4bn in order to attempt to clear regulatory hurdles erected by the FTC. Otezla is estimated to have peak sales of ~$3bn. With Skyrizi off to a significantly faster launch and much higher estimates for peak sales ($5BN+), it is fair to estimate that the lifetime value of Skyrizi will prove significantly greater than Otezla. Abbvie has already increased its 2019 Skyrizi sales (8 months of sales) forecast to $250mm. That’s more than cumulative Otezla revenues in its first 15 months post launch.

The primary point with regards to Humira replacements is this. Abbvie has two replacement drugs that are both proving more efficacious (in their approved indications to date with many more to come) and one of which has a more desirable method of delivery (oral vs. injectable). Importantly, these two drugs have been launched in 2019 which means they each have more than three years of runway to build a substantial revenue base before Humira runs into its US loss of exclusivity. By then, both drugs are likely to be multi-billion-dollar sellers growing at a very compelling rate which means they will have the scale and growth necessary to help combat the loss of Humira exclusivity in the US. Further, as Humira is a biologic, it is unlike a small molecule oral drug and is likely to see a more moderate decline in US sales, upon expected biosimilar competition, than it would if it were a small molecule oral drug.

Recognizing that Abbvie has established great, next generation replacement drugs for Humira, there are a few other strong selling points for Abbvie’s stock.

The Allergan acquisition should put Abbvie in a much better position come Humira’s 2023 US loss of exclusivity.

Humira drops from 59% of standalone Abbvie sales in Q2 2019 to 39% of Pro Forma Abbvie/Allergan sales in this past quarter. But more importantly in addressing the 800lb guerrilla concern about 2023, because 1) Humira is already in modest WW sales decline (because of the loss of exclusivity in Europe) 2) Abbvie’s core growth businesses continue are projected to continue to deliver robust growth over the next 5+ years 3) Allergan’s core business is forecast to provide modest but consistent growth over the next five years and 4) Humira is not likely to go through a catastrophic decline in revenues in its first year of US biosimilar competition (maybe 33-35%), New Abbvie is a) likely to only suffer a mere <8% decline in total revenues in 2023 and b) in 2022 Humira is likely to represent less than 1/3 of revenues vs. its ~40% of pro forma revenues currently (and almost 59% of standalone revenues currently).

Abbvie is positioned to generate highly compelling free cash flows and increasing free cash flow per share through 2025!

One of the most gratifying and welcome elements of these pharma deals that include stock is that the proxy includes fairness opinions with company forecasts going out well beyond many sell-side analysts. This is particularly helpful with Pharma companies that are, at the end of the day, all about forecasting out the likely success of various products over their useful patent lives (and beyond).

The above unlevered free cash flow projections come directly from the proxy and combines the mid-point of the Allergan high and low growth scenarios with the Abbvie forecasts. Despite its rich dividend yield, Abbvie has committed to annual dividend increases for the foreseeable future. I have estimated a three-cent annual quarterly dividend increase in each of the next five years. I have also made some broad assumptions on the average interest rate on debt (4.5%) and a 21% tax rate. Finally, I’ve assumed that all FCF after dividends will be used for debt reduction over this forecast period – which is certainly likely to be the case for at least the next 2-3 years.

Three observations especially worth highlighting. First, with the combination of Abbvie and Allergan, the Companies are effectively forecasting no meaningful diminution of unlevered free cash flow over the 2023-2024 period despite the loss of Humira US patent exclusivity. This is clearly being driven by the strength of the non- Humira product portfolio, benefits of the expected cost synergies from the combination with Allergan and, in all-likelihood, less loss of FCF from the loss of Humira US exclusivity than most investors fear (it’s not just about the loss of revenues – when a drug loses exclusivity there are also things that can be done on the cost side to mitigate the FCF impact).

Second, over the next five years should Abbvie choose to do so, it should be able to retire debt in excess of what will be issued (approximately $40bn) to fund the transaction just from the use of excess free cash flow after dividends.

Third, by aggressively paying down debt, Abbvie should be in a position to deliver increasing FCF per share through at least 2025. At Abbvie’s current share price, it’s FCF yield should start at ~11.5% and graduate to almost 14% in 2025. Over the next five years, Abbvie appears to be in a position to generate ~65% of its pro forma market capitalization in free cash flow!

Disclaimer – I purposely kept the model on the prior page high level.

If only you could buy a bond with the financial characteristics of Abbvie’s stock (especially given Abbvie’s credit profile)

One of the truly special features of an investment in ABBV shares is the cash payout profile of the Company. Abbvie’s current dividend yield is 5.9%. Assuming a 20% dividend tax rate vs. 35%+ tax rate on interest income, Abbvie’s pretax bond equivalent yield is ~7.3%! But as opposed to a fixed rate bond, Abbvie has made a stated commitment to continue to increase its dividend on an annual basis for the foreseeable future. Assuming a modest (probably too modest) three cent per quarter increase in the dividend on an annual basis, Abbvie’s dividend yield would grow to 6.7% (assuming no share price increase) and its pre-tax bond equivalent yield would grow to ~8.3% by 2024!

So not only is Abbvie forecast to deliver a compelling FCF yield over the next five years, about half the FCF is likely to be directly delivered to shareholders via dividends. And this is all happening in the context of an investment grade credit (Baa2 at Moody’s and maybe downgraded in the context of this merger to BBB+ at S&P). Not only should FCF yield and high dividend yield investors find an investment in Abbvie shares highly compelling, so should, arguably, “unconstrained” bond fund PMs!Final compelling element of an investment in Abbvie – abjectly low valuation

Referencing back to the initial table on page one of this Part II of this report, on a standalone basis Abbvie trades at a 45%discount to its peer median forward EPS multiple. On pro forma basis, that discount to the peer median drops to 50% (or <7x 2020 pro forma EPS). There is no cheaper stock in the peer group than Abbvie. That discount is unwarranted and due to correct. For those that point to the Humira issue as justification for such a steep discount, I submit that I’ve sufficiently addressed that debate earlier in this report. For those that point to merger arbs contributing to the discount, I’d highlight that that issue is likely to fully resolve itself in Q1 of next year when the Allergan deal closes. That’s one of the factors that makes an investment in Abbvie at this juncture so compelling and opportunistic. For those that point to broad concern about drug pricing headline risk during this contentious presidential cycle forcing investors to be particularly fickle in their pharma investments, I point to a) the last 25 years of history on incremental, political moves on drug pricing (I’ll leave it to the reader to surmise which side has consistently outmaneuvered the other) b) the fact that Sen. Mitch McConell has already fully rebuffed Rep. Nancy Pelosi’s DOA wish list on drug pricing and c) if one is really worried about this issue, would one rather being in the highest or lowest p/e stock in the peer group?

The sell-side has largely yet to transition their models to pro forma Abbvie (which will lead to a meaningful boost in forecasts and presumably target prices). I submit that once the buy and sell-side start focusing in more earnest on how things are likely to play out with Abbvie’s future results, the enormous discount that Abbvie trades at will shrink. And once we weather this full presidential cycle, it is just as likely that we see the broader pharma sector’s discount to the broader market shrink as we are to see it remain the same. I believe that three years from now we should be seeing Abbvie trading at at least 12x 2022 rather than its current <7x pro forma 2020 forecasts. 12x 2022 would equate to ~$160 per share and when also adding dividends, that would lead to a total accumulated value of ~$173. The IRR for such an outcome is approximately 34%. I believe that reasonable outlook makes Abbvie a conviction buy.

Whether to buy Abbvie at this juncture or Allergan

There are a few things to take into account in terms of that calculus: what’s your tax status (do you care about long vs. short-term gains), income needs and level of concern over the risk that the Abbvie/Allergan deal closes. Assuming that you’re a hedge fund (and not worried about establishing your longer-term hold period), that you are indifferent on near term income and that you think the ABBV/AGN deal closing is a lock, then the math says the only other determinant you should care about is where ABBV’s stock closes at the time of the transaction closing. The way the math works, if you believe that ABBV stock will be trading above ~$82 (~11% above current), then you want to buy ABBV. Otherwise, you want to buy AGN (and then roll the cash consideration of the deal into ABBV upon closing). Arguably, the smartest way to play the deal, in my opinion, is to buy both AGN and ABBV in equal parts.

Risks:

–  Long-term ABBV looks worse without Allergan, but short-term if the deal breaks Abbvie stock should go higher (merger arbs get punished).
–  Drug pricing reform headline risk (again see the piece I alluded to in Part 1 of this report).
–  Poor execution either as a standalone company or in terms of its integration of Allergan.
– If you’ve read this report, the other major ones are covered or implied.

www.fourtreeislandadvisory.com

Disclaimers: All information gathered from sources believed to be accurate, but the accuracy of the information cannot be guaranteed. Past performance is no indication of future results. A number of points made in this update are a matter of opinion and opinion is subject to change without notice.