Specialty Pharma: In Search of Value Beyond the Headlines
The last 10 years have seen the longest uninterrupted equity bull market run post-World War II, with central banks’ quantitative easing efforts producing low interest rates, which in turn facilitated rising equity valuations. Over the years, we have witnessed the narrowing of valuation spreads between statistically inexpensive stocks relative to more expensive stocks. In practice, this has meant that equity managers, including Diamond Hill, have been presented with a dilemma: do you hold onto your well-performing stocks even though they may be reaching your estimate of intrinsic value (IV) or do you invest in new opportunities with potentially wider discounts to IV that are likely to be of lower quality? When stocks are valued close to one another, it makes long-term sense to pay up a bit and invest in higher-quality stocks, as those companies should sustain their return on equity given the stability of their cash flows and their ability to compound growth internally. When stocks are trading at wider valuation spreads, long-term investors should be more willing to consider giving up some quality in exchange for the extra valuation discount they would receive from investing in lower-quality stocks.
We then need to evaluate the level of dispersion within each sector, as it can offer clues about the value versus quality trade-off that we may want to strike within our portfolios. The chart in column two illustrates valuation spreads for each sector today versus their historical ranges (1950-2019). One industry, pharma and biotech, stands out in this chart, as the current valuation dispersion in the industry is about as wide as it has ever been (97th percentile). In other words, the market has almost never been as certain about what the potential winners and losers are going to be in this industry. Given that level of market confidence and those odds, we prefer to be contrarian, as we should be getting paid through excessive IV discounts to take on the risks that could lie ahead.
THE U.S. INTRA-SECTORAL VALUATION SPREADS1 CURRENT READINGS COMPARED TO LONG-TERM HISTORY PERCENTILES (1=NARROWEST, 100=WIDEST), 1950 THROUGH MAY 2019
Source: Empirical Research Partners Analysis.
1 Based on an analysis of a 1,500 stock universe. Framework varies across sectors depending on what’s efficacious.
One group that exemplifies this profile and where we have been finding more attractive long-term investment opportunities is the specialty pharma/generics group within pharma and biotech. The sell-off that companies have seen this year has allowed us to invest more meaningfully into companies like Perrigo, Allergan, and Endo International, where we see potentially excellent long-term returns. While investors continue to be concerned about balance sheets and litigation risks in this space, they are disregarding some important positive developments during the last year that we believe bode well for the future.
First, there have been changes in key leadership positions at most of the firms in this space. Teva, Endo, and Perrigo have each brought in executives that have previously dealt with balance sheet and litigation issues and have the necessary fix-it mentality. Perrigo is a prime example of this trend, as the arrival of the new CEO, Murray Kessler, has been a breath of fresh air for the company and the industry overall. Kessler is an outsider who is willing to rethink the competitive landscape and shift the strategy of the company more towards self-care to align with the changing consumer landscape. His background in the tobacco industry has equipped him to deal with the claw-back taxation issues that Perrigo is facing. In addition, Kessler has an eye for good tuck-in acquisitions, which will likely be the cornerstone of his tenure as he plans to return the company to growth. For example, Kessler led the recently announced acquisition of Ranir for $685 million, which expanded Perrigo’s private label footprint into dental care. Kessler has brought in a fresh innovation team with him and it is reasonable to expect a higher level of new product development going forward, something that has been lacking over the last five years. It is CEOs like Kessler who can bring about culture change that companies in this space are yearning for.
While we believe the outlook is promising for Perrigo, other companies, such as Allergan and Mylan, have not yet seen executive changes. As a result, shareholders have been voting with their feet and signaling that a change in personnel or portfolio structure is necessary to improve returns. In Allergan’s case, management, headed by CEO Brent Saunders, resisted rationally assessing their own performance and the company’s strategic direction. Despite stacking the board with friends, thinking his position would be protected, Saunders underestimated that those same friends would have a fiduciary responsibility to act in the best interests of shareholders. Shareholders, including Diamond Hill, have been looking for a split of Allergan, if not an outright sale. We believed that in either scenario, the stock would be worth at least $215 to $220 per share given the quality of the company’s aesthetics portfolio, which includes Botox, Juvederm, and Coolsculpting. With shares trading as low as $114 in mid-June, it seemed to us that Allergan was effectively trading at half of its IV. Typically, that type of valuation discount attracts financial if not strategic buyers, which ultimately happened. On June 24, AbbVie announced that it had struck an agreement to purchase Allergan for $120 per share in cash and 0.87 AbbVie shares for each Allergan share, or total value of $188.24 per share. While not an ideal price, AbbVie’s valuation of Allergan represents a clear signal to the market that the discount in the specialty pharma/generics space has been excessive, as Allergan was trading at 7x 2019 earnings per share estimates and was sold at 11x. Investors will now have to reassess how they value the entire specialty pharma/generics space considering the floor that AbbVie’s offer represents, something that should have positive implications for our other holdings, including Perrigo and Endo.
Another industry trend that has been overshadowed by negative near-term headlines is the potential stabilization of the generics market. In late 2017 and most of 2018, the industry saw double-digit annual pricing declines due to the consolidation of generic buyer consortiums headed by pharmacies and drug distributors. However, those pressures have abated in 2019, with June being the first month in two years in which generic drug prices increased. Pricing should be more manageable going forward since consolidation on the buyer side has slowed. It is quite likely that the generics group could show revenue growth in 2020, which Endo foreshadowed on their first quarter conference call. We continue to like Endo’s risk/reward profile heading into the opioid trial and potential settlements later this year. The company has a strong specialty injectables business, a durable and growing asset in Xiaflex, and likely $450 million to $500 million in annual free cash flows starting in 2020, as they finalize their mesh liability payouts. The management team, headed by CEO Paul Campanelli, has rationalized costs to protect cash flows and should have a very interesting asset in CCH (repurposed Xiaflex for cellulite) for potential commercialization next year. An oversubscribed debt offering earlier this year allowed Endo to push out near-term liabilities and have more financial flexibility. In the near term, investors will be following the opioid headlines. Our analysis points to investors expecting more than $5 billion in opioid liabilities, which seems excessive. In our view, a more reasonable estimate of opioid liabilities indicates Endo is significantly undervalued, especially considering the implications of Abbvie’s offer for Allergan. We see a potentially underappreciated opportunity in the making, with the company selling at less than 0.4x our estimate of IV.
The specialty pharma/generics industry may appear to some as a collection of sub-par businesses that could turn out to be value traps. Certainly, that is a possibility and something we cannot know for sure. However, sometimes the IV discount for a company more than offsets the lack of quality in the business. As the adage says, a good company is not necessarily always a good investment and vice versa. Keeping in mind the current valuation spreads in the pharma and biotech industry, that is precisely the direction we lean today.
As of June 30, 2019, Diamond Hill owned shares of Allergan PLC, Endo International PLC, and Perrigo Co.
Originally published on July 31, 2019.
The views expressed are those of the research analyst as of July 2019, are subject to change, and may differ from the views of other research analysts, portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.