9/19/19

Buy Allergan for a five month 26-37% IRR opportunity. Buy Abbvie for a three-year 20% compounder opportunity

“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

The above quote could easily and arguably be directly alluding to Abbvie. More on that in Part II of this report.

This write-up is going to be broken down into two specific parts: Part I) a break-down on the compelling near-term opportunity in Allergan plc shares and Part II) the even more compelling medium-term opportunity in Abbvie shares. For the avoidance of any ambiguity, my firm is long both stocks and has weighted various investors in one vs. the other stock based on individual client specific short vs. long-term objectives.

This report recommends two ways to capitalize on the deal:

Recommendation for short-term oriented investors: Buy Allergan (~$166) on the assumed takeout by Abbvie at anywhere between the current implied takeout price of ~$181 and ~$189 per share (I believe that there’s a reasonable likelihood that ABBV’s stock increases to the mid-to-high $70s by the time of close of the deal which would result in a deal value of $185-$189).

Recommendation for medium-term oriented investors: Buy Abbvie a) opportunistically taking advantage of the dislocation that this deal has created in ABBV’s share price and b) as a hedge in the low likelihood event that the deal is scuttled.

Discussion on the opportunity in Allergan shares:

Abbvie’s acquisition is very straightforward in terms of how it has been structured. The consideration for Allergan is approximately 2/3 cash and approximately 1/3 Abbvie stock. Further, Abbvie smartly structured the offering such that no Abbvie shareholder vote is required because the amount of Abbvie stock being issued is below the 20% threshold at which the NYSE requires that a shareholder vote be taken. The only shareholder vote that’s required is one by Allergan shareholders. Given that Allergan shareholders are lined-up to receive, based on Abbvie’s current price, at least a 40% premium to the stock price AGN was trading at prior to announcement of the transaction (and that all the arbs will be voting for this deal to close), a positive Allergan plc shareholder vote is all but assured.

Based on the calculations highlighted on the table on page one, assuming that ABBV’s stock closes where its currently trading at the time of the deal close, then the IRR to close of this transaction is approximately 26% by purchasing AGN’s stock at its current $166. This assumes a mid-February close and is consistent with Company guidance that this deal is likely to close in “early 2020.” Should Abbvie’s stock recover to $75 at the time of the deal close (I will discuss in depth later why it could very well be at $75 or higher but for now worth knowing that the stock traded a $78.45 prior to the deal announcement), then that IRR could increase to 30%+.

As this deal was announced while we’re still amidst the Bristol/Celgene deal working its way towards completion (and that deal is fresh in people’s minds), it’s worth highlighting some of the key differences in the deals:

As indicated in the table on the prior page, there are a number of elements in this deal that make it look a) even likelier that this deal will close than Bristol’s purchase of Celgene looked at the outset and b) less risk for Allergan shareholders. And I submitted from the beginning, in my prior BMY/CELG write-ups, that the likelihood of that deal closing was very high.

In this deal, the cash / stock mix is much more cash weighted making the deal price risk much lower for the Allergan investor. In Bristol/Celgene, not only is ~49% of the consideration in BMY’s stock (which is subject to daily change), but then there’s also ~2- 3% of the consideration that comes in the form of CVRs which are subject to meaningful swings in value.

The value of no shareholder vote to closing the deal shouldn’t be underestimated. A shareholder vote by the acquirer’s shareholders is a key leverage point for activist involvement and could have been a problem for this deal.

One of the issues that surprised most of the investor community, and seemingly Bristol/Celgene, was that the FTC required the divestiture of one of the Bristol/Celgene two oral psoriasis therapies (even though one of those two therapies has yet to be approved by the FDA). In the Abbvie/Allergan situation, Abbvie noted upon announcement that there were a couple minor areas of overlap and they were fully willing to divest key products in those areas to assuage any potential FTC concerns. Subsequent to that initial indication, Allergan has announced that it plans to divest Brazikumab which could have ended up competing with Abbvie’s recently (2019) FDA approved Skyrizi (which is on a tear) and Zenpep ($133mm of 1H sales) which was a direct competitor with Abbvie’s Creon ($484mm of 1H sales).

The fact that this is a cross-border deal probably means added scrutiny by European regulators, but the FTC has proved stringent on big pharma deals so the European Commission may largely defer to the FTC.

That all said, what matters most when evaluating the opportunity in Allergan shares at this juncture is understanding the key risks.
Key Risks:

Deal closing risk.
Timing of the closing risk.
Abbvie stock price risk.

Discussion of Key Risks

Deal closing risk – While I believe there’s a better than 97% chance that this deal closes, there are, maybe, four potential ways that this deal could be scuttled that warrant discussion.

Abbvie walks on the deal due to concerns over either opioid exposure, breast implant exposure, or some combination of the two.
Abbvie walks on the deal due to some major change in drug pricing.
Abbvie walks on the deal due to overly aggressive regulatory scrutiny of the deal.
An interloper makes a successful bid for Abbvie thereby scuttling the deal.

Opioid/Breast Implant exposure – There have been numerous questions of Abbvie since the deal announcement, given all the recent news of opioid cases for states like Oklahoma and a federal case in Ohio running through the courts, whether Abbvie is comfortable with the opioid exposure they’d be taking on with the Allergan acquisition. This appears to be an understood issue and of limited liability for the Company. Allergan had two forms of opioid exposure – through branded sales of opioids and through the sale of generic opioids. According to both Allergan’s and Abbvie’s representations, all the generic opioid exposure lies with Teva which bought Allergan’s generics business back in 2016 for $40bn. Teva has clearly indicated on two separate occasions, according to Allergan and Abbvie, that Abbvie is indemnified and Teva is responsible for any of the legal liabilities associated with the generic opioid products previously under Allergan’s umbrella. In terms of Allergan’s branded opioid exposure, Abbvie and Allergan represent that Allergan was a small player in the branded market and that their sales practices were of high caliber. Abbvie believes the exposure that Allergan has for its branded opioid business is small and that is highlighted by a recent settlement for $5mm for a landmark federal opioid trial being tried in Cleveland in October. Allergan represents that it “hasn’t actively marketed or promoted any opioid products since 2013” per the attached article in WSJ from Aug 30, 2019 (https://www.wsj.com/articles/allergan-to-pay-5-million-to-settle-ohio-opioid-suit- 11567166120). In summary, based on Abbvie representations opioid exposures were well understood going into this deal and they are not perceived to be material in the context of the value creation potential of the combination.

What I haven’t heard any questions on, but I believe will eventually gain some investor attention, is what exposure Allergan may have in terms of textured breast implants. This has been a known issue since late last year in Europe when Allergan’s textured breast implants were pulled from the European market. This Summer the issue became more consequential (because the exposure was larger) when the FDA brought pressure to bear and Allergan instituted a voluntary recall of their Biocell textured breast implants in the U.S.. These implants appear to have a 6x higher incidence of a type of breast implant associated lymphoma than other breast implants made by other manufacturers.

Based on available data, Allergan had approximately $68mm of breast implant sales last quarter which represented <2% of Allergan’s total sales. Of that $68mm, less than half of the breast implant sales were of the type that have experienced the voluntary recall. The bulk of Allergan’s breast implant sales are of smooth, not textured, breast implants. Point being while this situation is very unfortunate, this is not a big business for Allergan and it’s likely that the exposure, net of insurance, are likely to be very manageable for Abbvie and something that won’t derail the combination.

Risk of drug price legislation scuttling the deal – in many ways, one of the significant attractions of this deal for Abbvie is it provides Abbvie with significant exposure to elective, cash pay therapeutics. By far the biggest part of Allergan’s business is its Medical Aesthetics business namely Botox, Juvederm, Alloderm and Cool Sculpting. This broad business is over 40% of Allergan’s sales and its typically cash pay, typically non-reimbursement, type business. These therapies are not the primary targets of most of the legislative efforts in Washington to rein in drug spending. Further, one of the primary benefits of the Abbvie/Allergan combination is $2bn of expected run-rate synergies that will help the companies combat the impact of any successful legislative efforts to reign in drug pricing. Additionally, most of the major initiatives being contemplated in Congress with any real chance of success are likely to only be incremental and modest – not something that is likely to scuttle this deal. That all said, Abbvie will be putting on approximately $40bn of debt to complete this deal and if something highly surprising comes along to radically change the US drug pricing landscape, this deal could certainly be pulled.

Likelihood that this happens, very low. For more discussion on this topic, I direct readers to view the update I published to my Bristol-Myers report on 7/16/19 on SZ entitled “Opportunity Surrounding Strong Rumors of Most Favored Nation Pricing of Pharmaceuticals for Medicare.”

Risk that the FTC or European regulators intervene too heavily – given that Abbvie and Allergan have already indicated a clear openness to divestitures of anything with significant overlap and have already announced the intent to divest two drugs, proactively, a month after the acquisition announcement, this risk seems very low. But we shall see. The initial HSR review period has passed and there has been no announcement – which in all likelihood means there’s been an extension and Abbvie has not deemed it appropriate yet to advise the investor community on where things stand. This could be because the FTC and Abbvie are very close to agreeing to any and all needed remedies or because they are heavily negotiating. From a high level – overlap here looks even less than in the BMY/Celgene deal and there should be a lot less domestic political concern given the cross-border nature of the deal. In fact, this is a situation where the US is actually gaining back a Company that once was a US domiciled company (for tax purposes).

Risk that an interloper makes a successful run for Abbvie and thereby busts the Abbvie Allergan deal

The risk that this happens is exceedingly low for two reasons: 1) there has been virtually no talk of it and there doesn’t appear to be any activist focus on finessing such a bidder and 2) Abbvie has a tremendous poison pill by way of its $20bn in annual sales blockbuster drug Humira (representing 60% of standalone Abbvie sales) which is likely to lose US exclusivity in 2023 – a mere three years from now. Risks around Humira are the primary reason Abbvie has entered into the deal with Allergan. The rationale is that this deal should sufficiently diversify and enhance the new Abbvie so that Humira’s 2023 challenges won’t overwhelm standalone Abbvie and its shareholders. But Abbvie on a standalone basis has a monumental challenge come 2023. It’s basically inconceivable that any of the other pharmas that could purchase Abbvie would consider doing so at this juncture (a deal would be at least $130bn of equity value) given the uncertainty around Humira.

In sum, I stand by my estimate that there’s a 97%+ chance that this deal closes.

Timing of the closing risk

The Abbvie/Allergan combination was announced on June 24, 2019 and the continued guidance from Abbvie management at recent conferences is that the deal is still expected to close in early 2020. There’s only one shareholder vote to worry about and that’s Allergan’s (a slam dunk) that will be taking place on October 14. It took the European Commission just over six months to provide unconditional approval to the Bristol Celgene deal. Based on that same timing and less product portfolio overlap than in the Bristol Celgene deal, European Commission approval should come by January 2020. Given a more conciliatory approach to the FTC than originally taken by Bristol/Celgene and again the limited overlap, it can fairly be expected that gaining FTC approval should take no more than six months. Tack on an extra month and it seems eminently reasonable to assume a mid-February close. But as is always the case, this is really up to the regulators. Earliest the deal could be done is probably December, the latest would seem to be March.

Abbvie stock price risk

Approximately 1/3 of the consideration for Abbvie is being paid in Abbvie shares with a fixed exchange ratio: 0.866 Abbvie shares for every AGN share.
Understanding where Abbvie’s stock is and where it may ultimately shake out at the time of close of the transaction is important to assessing the opportunity in going long AGN in anticipation of the deal closing.
Abbvie’s stock is down 42% from its early 2018 $123 high despite EPS in 2019 that is expected to be (IBES consensus) 58% above 2017’s results! ABBV’s poor stock performance is even more starkly highlighted when comparing to Vanguard’s Healthcare ETF (which has six of its top 10 holdings large cap pharma stocks). See below.
Deal Announcement
Abbvie’s stock is trading at 76% of its 52-week high and 58% of its two-year high. More importantly, other than Bristol-Myers Squibb on a pro forma basis for the Celgene combination, there is no cheaper mega cap pharma stock than Abbvie (either pro forma for Allergan or without Allergan). Even more importantly, 1) despite the proposed acquisition of Allergan being 10-20%+accretive to Abbvie forecast earnings over the next 3+ years (Abbvie guidance), Abbvie’s stock is down ~9% since the Allergan deal announcement and 2) the median stock price performance of Abbvie’s large cap peers is -1% vs. Abbvie’s -9%.

Surely arbitrage activity has contributed to Abbvie’s underperformance since the deal announcement, but a) Abbvie is exceedingly inexpensive b) as we come closer to the likely close date of the transaction and the remaining hurdles for deal completion are crossed, the sell-side community is likely to become increasingly constructive on this situation and, I submit, Abbvie’s stock is likely to gravitate back to the mid-to-high $70s.

There are some on the sell-side that are starting to plug into the opportunity. UBS’s Navin Jacob came out on September 12 with an opportunistic and timely upgrade on Abbvie’s stock and increased UBS’s TP on Abbvie to $79. At that price, the takeout price for Allergan climbs to $189 representing a ~14% premium to AGN’s current price and an IRR to close of ~37% (assuming February 15, 2019). Morningstar has been pounding the table on the opportunity in Abbvie shares ever since the deal was announced and sees $102 as fair value for Abbvie stock. Further, of significant note Abbvie has been making tremendous headway on its emerging drug portfolio with an impressive launch of Skyrizi (oral medicine used to treat plaque psoriasis) that’s beating all expectations and the recent FDA approval for likely soon to achieve block buster status RINVOQ (an oral JAK inhibitor for the treatment of rheumatoid arthritis).

Upshot on ABBV stock price risk is this. While Abbvie and all the other large pharma stocks are in the middle of a presidential election cycle and rumors and announcements of potential drug price reform are inevitable, the fundamentals suggest that the bias to Abbvie’s stock is materially to the upside. I submit that investors contemplating an investment in Allergan bracket their expectations for ABBV’s stock price from $71-79 per share by the time the deal closes.

Summarizing the risk discussion on a purchase of Allergan in the context of its takeout by Abbvie

Without question the biggest risk of the three sets of risks around Allergan is the deal closing risk. But not only do I believe that each of the reasons (previously cited as possible rationales for the deal not closing) are readily dismissible, it is important to keep in mind why Abbvie is hell bent on closing this deal. Abbvie has a big unknown come 2023 in terms of Humira. This deal puts Abbvie in a position to have 60+% of its
revenues coming from therapies that in the aggregate are forecast to have a high single digit growth rate. Abbvie will be better diversifying its payor base with a much greater cash pay, non-reimbursement oriented payor base. Abbvie will be in a position to take out over $2bn of anticipated cost synergies. And Abbvie should be able to reduce virtually all the indebtedness it takes on in the deal (should it decide to do so) within three to four years of the deal closing. Given the cash/stock consideration mix for Allergan, Abbvie is effectively executing a leveraged buyout of Allergan and announced that buyout at a time when Allergan was trading at its 5-year lows and just 38% of its 5-year high stock price! Highly opportunistic move on Abbvie’s part.

Summarizing the Opportunity in Allergan Shares

At this juncture, the gross gain potential would appear to be between ~10-14% and the IRR potential lies somewhere between 26-37% assuming a mid-February 2020 close and an Abbvie stock price that falls between the low and high $70s at the time of close. This is a deal that was well vetted by both parties and the backgrounds of both companies going into the transaction are cause for near insurmountable momentum pushing this deal across the goal line. Not only are both parties highly motivated to see this deal close, so are the advisers and financiers. The M&A fee for Allergan’s adviser (JPM) stands as the largest disclosed M&A fee of all time – $123mm (https://www.ft.com/content/b12c118e-bde3-11e9-89e2-41e555e96722). This deal was structured to make it exceedingly likely that it closes and there has been no indications since its announcement about three months ago that there are any forces out there that would change that.

Buy Allergan for a highly attractive, largely market-risk independent IRR of 26-37%.

I will publish Part II of this report, focused on why Abbvie is an, arguably, even more attractive medium-term investment opportunity, separately within the coming days.

Stock Price
Mkt Cap (bn)
% of 52 Wk Hi
Net Debt (bn)
Ent Value (bn)
TTM Sales (bn)
TTM EBITDA (bn)

EV / TTM Sales
EV / TTM EBITDA
P / 2019 IBES
P / 2020 IBES
P / 2021 IBES
J&J
$130.11
$343
87%
$11
$354
$81
$28

4.4
12.6
15.1
14.3
13.3
Merck
$83.95
$215
96%
$11
$226
$44
$17

5.1
13.3
17.1
15.3
13.7
Pfizer
$36.44
$202
78%
$22
$224
$54
$22

4.2
10.0
12.9
13.0
12.1
Amgen
$195.65
$117
92%
$8
$125
$24
$12

5.3
10.3
13.7
12.4
11.5
Eli Lilly
$114.12
$110
86%
$9
$120
$23
$7

5.2
16.6
20.1
17.3
15.3
Bristol-Myer
s $49.97
$76
78%
-$7
$69
$24
$7

2.9
10.0
11.7
8.0
6.7

4.7
11.5
14.4
13.6
12.7

Abbvie
$71.69
$123
67%
$30
$153
$33
$15

4.7
10.3
8.1
7.6
6.8
Allergan
$165.73
$54
84%
$20
$75
$16
$7

4.8
10.4
9.9
9.8
9.2

ABBV Disount to Peer Median
-1%
-11%
-44%
-45%
-46%

AGN Discount to Peer Median
1%
-9%
-31%
-28%
-28%
www.fourtreeislandadvisory.com
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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.