We have witnessed numerous examples over the years of biotech/pharma companies selling-off over fears of the length of patent protection on an essential product. The concern is well-founded–if the company relies on the product for a significant portion of sales, it may be challenging to replace, especially if the clinical pipeline is relatively bereft of viable next-generation products. We believe the recent sell-off in the shares of Allergan may now be wholly factoring in the loss of patent protection of one of its core assets in Restasis, and the equity may not be getting enough credit for its highly diversified revenue stream.
By Alexander J. Poulos and Kris Rosemann
Overview
Allergan (AGN) in its current configuration is an amalgamation of a series of transactions rooted in the generic drug field. Allergan and the rights to the name were purchased in 2015 by Actavis under the guidance of CEO Brent Saunders, a consummate dealmaker but one that lacks an in-depth background in science. Such a background is worth noting as Allergan has embarked on an unusual strategy of under investing in R&D. Instead, the company prefers to purchase promising molecules in trial phases 1-2 and bring them to market. We have a great deal of respect for Saunders’ business acumen due in part to the sale of the legacy Actavis generic division near a peak in the generics market to Teva Pharmaceuticals (TEVA). The deal completed the transformation of Allergan into a pure-play branded drug company instead of a hybrid business with a considerable emphasis on generic medications.
Restasis
The uncertainties over the patent life of dry-eye treatment Restasis in our view have placed undue pressure on the equity. Restasis IP estate is secured through six unique patents that expire on August 27, 2024.
Restasis® IPR. On June 6, 2016, Allergan, Inc. received notification letters that Inter Partes Review of the USPTO (“IPR”) petitions were filed by Mylan Pharmaceuticals Inc. (“Mylan”) regarding U.S. Patent Nos. 8,629,111 (the “‘111 patent”), 8,633,162 (the “‘162 patent”), 8,642,556 (the “‘556 patent”), 8,648,048 (the “‘048 patent”), 8,685,930 (the “‘930 patent”), and 9,248,191 (the “‘191 patent”), which patents expire on August 27, 2024.
Source: Allergan’s 2016 10-K page F-96
Allergan suffered a setback after the US Federal Court in the Eastern District of Texas struck down four of the six patents that protect Restasis from generic competition. The ruling invalidated the 111 patent, the 048 patent, the 930 patent and the 191 patent, but the 162 and 556 patents were not struck down and will continue to protect Restasis. Allergan announced it would appeal the verdict, which will push the next decision well into 2019 as the appeal works its way through the court system. The company recently settled its patent dispute with Famy Care with a confidential settlement in which Famy Care will dismiss its litigation against Allergan in exchange for a license to distribute a generic version of Restasis on February 27, 2024, roughly six months prior to the listed expiration of the IP estate covering Restasis.
According to management’s guidance concerning the timeframe in which IP protection can be lost on Restasis, the most pessimistic scenario is loss of IP protection in the first half of 2016, which is in line with the expected appeals process timeline. The company believes it should be able to maintain IP protection well into the next decade, but it is important to note that IP challenges are notoriously difficult to handicap, as evidenced by other recent IP challenges such as AbbVie’s (ABBV) Humira and the litigation between Amgen (AMGN) and Regeneron (REGN) regarding the fate of the PCSK9 category.
Image Source: Allergan
Restasis is well into the terminal phase of its product lifecycle–sales dropped more than 9% to ~$354 million in the second quarter of 2017–but its decline has not hindered Allergan’s ability to grow its overall revenues. Shire Plc (SHPG) has brought to market a competing product (Xiidra) that has managed to capture nearly 20% of the overall dry eye market. Shire has made an aggressive push to continue gaining market share with free sample coupons, but favorable formulary placement remains elusive. Here’s what we had to say on the matter in September of this year:
We remain impressed with the current growth trajectory of Xiidra, Shire’s recent entry into the lucrative dry-eye market. Industry-leader Restasis continues to dominate the market with a near-100% market share the past few years. Xiidra has captured a significant portion of the overall market thanks to some aggressive marketing on the part of Shire. We remain bullish on the prospects of Xiidra, but we wonder if the proposed split off the company were to come to fruition, Xiidra would lack a logical home. The product would not be a logical fit for the Neuroscience division as the disease states offer little in the way of potential sales rep overlap. The same can be said with the remaining Rare Drug stump, thus leading to our commentary of an excellent product lacking a natural home.
Source: Shire Plc Continues to Underwhelm
Though investors never want to see an earlier than expected loss of IP protection, Restasis accounted for less than 10% of Allergan’s overall sales in the second quarter of 2017, making its patent defense somewhat less pressing than other recent examples such as AbbVie’s battle over Humira. The company’s product pipeline is nicely diversified, but concerns remain regarding the lack of a blockbuster treatment outside of Botox. Nevertheless, Allergan is a master of the mid-sized products (sales of $300-$500 million) with significant assets in medical aesthetics.
Medical Aesthetics
The reimbursement dynamics in the medical aesthetics field are very favorable as most products are not covered by third-party plans, limiting price competition. Pharmacy benefit managers (PBMs) such as Express Scripts (ESRX) exclude the vast majority of these products from product formularies, thus a patient who seeks such treatment must be willing to pay out of pocket for the procedure. Allergan is actively building out a complementary suite of products beyond its top-selling brand Botox, with non-surgical fat-reduction treatment Cool Sculpting a natural extension.
We estimate the demand for surgical correction for a wide range of aesthetic conditions such as excess belly fat (Cool Sculpting), the double chin, which is termed Submental Fat (Kybella), a full line of fillers, and the elimination of wrinkles (Botox) will continue to drive solid growth for Allergan. The field does exhibit some cyclical tendencies as the procedures are elective at the consumer level–any economic downturn impacting consumer spending levels may decelerate the pace of treatments.
Balance Sheet
Allergan has a bloated balance sheet with $30.2 billion in total debt–compared to just over $5.8 billion in cash, cash equivalents, and marketable securities–and nearly $49.6 billion in goodwill, the side effects of years of dealmaking. The company’s net debt-to-adjusted EBITDA came in at 3.2x as of the second quarter of 2017. To management’s credit, it has largely refrained from major deals, but Allergan will likely continue to be a “work in progress” as it builds out its product line-up via additional tuck-in acquisitions over the medium term.
In an attempt to broaden the investment appeal of the company, Allergan utilized a portion of the proceeds from the Teva transaction to initiate a quarterly dividend of $0.70 per share in Spring 2017, as well as a $10 billion accelerated share repurchase plan (ASR). The ASR was completed in the third quarter of 2017, and Allergan recently unveiled an additional repurchase program of $2 billion, as well as reaffirmed its commitment to annual dividend increases and the repayment of $3.75 billion in debt in 2018. This capital return plan appears to be striking a nice balance between balance sheet health and capital returns to shareholders.
Valuation
We currently value shares of Allergan at $284 per share, and upside to this mark may very well exist in Allergan’s clinical pipeline as it remains a “work in progress.” Shares of Allergan are currently changing hands around $190, a meaningful discount to our fair value estimate and good for a price-to-earnings ratio of less than 12 times when using the midpoint of 2017 guidance. The market continues to punish shares for the uncertainty surrounding Restasis, and a bloated balance sheet is not helping its case. Nevertheless, management looks to have a solid grasp on its business, and we applaud Allergan’s decision to hold the line on pricing to the current rate of inflation as it demonstrates an awareness of the critical issues facing the industry.
At this point, we view Allergan as a company that has a reasonable foundation and growth opportunities, but also as one working to shake some of the negative storylines surrounding its business. It may very well be the case that Allergan is able to deliver from its pipeline, or acquire and bring to market, a number of hit products that enable it to replace potential revenue loss from Restasis, but the uncertainty for the time being is too great for a large number of investors. We like management’s debt repayment initiatives, but we would like to see more consistent free cash flow generation and an established dividend before anointing management as master capital allocators. In the first half of 2017, cash dividend obligations came in at $612 million, a far from meaningless amount of cash going out the door that was previously non-existent and will only grow in coming years.
All things considered, Allergan may offer an intriguing investment opportunity for those willing to take on patent protection risk and the potential loss of revenue that may ensue, but we anticipate it could take several quarters before the company is able to work through the issues plaguing it and price-to-fair value convergence materializes. Though we say the market may be overreacting to the Restasis news, the combination of the Restasis situation, no clear revenue replacer in the pipeline, and a bloated balance sheet are enough to keep us on the sidelines for the time being.
Disclosures: Independent Healthcare and Biotech Contributor Alexander J. Poulos is long Regeneron Pharmaceuticals, Allergan, and Gilead Sciences.
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