Summary

AbbVie (NYSE:ABBV), the pharmaceutical giant, recently took a knock from the delay in the proposed acquisition of Allergan (NYSE:AGN) amid fears of an anti-trust case. But if approved, the impending takeover of $63 billion is likely to take place later in the year after the preliminary investigations by the FTC. The investigation seeks to evaluate if the new entity, will create an uneven playing field within its industry through gaining too much power over the competition.

AbbVie has seen its revenues of Humira declining in Europe as the company faces biosimilar competition in the region, with the trend expanding into the third quarter, which has reinforced the need to diversify. If Allergan is onboarded, we believe AbbVie would be able to attain single-digit top-line growth in the coming years, and the new portfolio will set the company for a healthy mix of more modern medicines.

The Allergan merger: Bought at a discount and already approved by the EU.

Since the announcement in June last year, the company saw a retreat in the market as the stock price went down. And it has yet to recover from the sentiment around the takeover. But the impending takeover of Allergan will certainly position AbbVie at the top of the market and as a leader in immunology. With the EU has approved the merger, the ball is now with the US Federal Trade Commission (FTC) as they review the transaction. The company is, however, confident that the deal will be concluded in the second half of the year; a prediction that we support.

Based on our view, the justification for the takeover is that AbbVie needs to diversify and become less dependent on Humira as the market will not be able to wade off competition beyond 2023. AbbVie also seems to have gotten Allergan at a hugely discounted price. The Allergan stock has suffered a devaluation on the stock market since its 2015 glory. With a failed merger with Pfizer (NYSE:PFE), AbbVie is getting in for less than a fraction of what Pfizer would have paid. And taking into consideration all the synergies that this merger poses to AbbVie, we believe this deal can turn out to be a real winner for the company.

New drugs approvals keep coming in

Another win for the company has been the approval by the Food and Drug Administration (FDA) of the new rheumatoid arthritis drug, Rinvoq, which widens the portfolio for AbbVie. The new pill will see the company sharing the pie with Pfizer's Xeljanz and Eli Lilly's (NYSE:LLY) Olumiant. AbbVie also has a chance to successfully launch its plaque psoriasis treatment Skyrizi. If the company successfully spins the launch and also adds the cosmetic solution from Allergan to the mix, the company will have the recipe for accelerated growth and a potential rebound of its stock.

Botox and other cosmetic products might surprise

If the merger is approved, we also believe that the wrinkle eraser Botox could result in higher than expected growth for AbbVie as the target market presents fewer challenges than those facing the pharmaceutical industry as products are paid off by clients, not their medical insurance, and less regulated. The fact is that AbbVie plans to launch a subsidiary for these types of products, Allergan Aesthetics, under the umbrella of the AbbVie-Allergan merger. The business will pave the way for increasing sales of cosmetic Botox as well as products such as dermal fillers, and chin-fat-fighters.

Hence, there are several benefits from the pending merger. First, we have the synergies related to the increased dominance of AbbVie in immunology. Secondly, we'll see the resources and sales channels to boost revenue streams across all product portfolios. Thirdly, we expect aesthetics products from Allergan to strengthen the brand recognition of the new entity. We also see improved sales of aesthetics as resources are concentrated in a special subsidiary, Allergan Aesthetics, and can make use of more powerful distribution channels.

The synergistic benefits of the merger will likely exceed expectations as the company enters into a new therapeutic area, aesthetics, and it is unlikely that competitors will have such a broad portfolio to boast of.

Figure 1: AbbVie Income Statement and Balance Sheet

Source: Morningstar

AbbVie has witnessed marginal revenue growth over the period from 2017. The revenue is dominated by the top three brands, which are Humira, Imbruvica, and Mavyret, which contributed around 82% of the revenue, and there is a need to diversify as the company's largest revenue earner soon will face increased competition from cheaper alternatives in the U.S.

Through diversification, concentration risk will decrease, which, in turn, will benefit the company in the long run. The balance sheet has also grown over the period. However, there is a reliance on debt as it has almost doubled from the 2017 value of $37 billion to $66 billion.

AbbVie also lost 10% shortly after the announcement of the Allergan deal, which is somewhat favorable as Bristol-Myers Squibb (NYSE:BMY) and Takeda (NYSE:TAK) were down by 16% and 32%, respectively, shortly after they made their respective M&A advances.

Figure 2: AbbVie Cash Flow

Source: Morningstar

AbbVie maintained the operating cash flow within the same band for 2018 and 2019 but saw a drastic decline in its financing cash flow from a 2017 figure of -$5 billion to a 2018 figure of -$14 billion satisfying a buyback strategy authorized in January 2018. The buyback indicates strength in the company's liquid resources and signals the potential for a rebound for its stock. As seen in Figure 3, AbbVie is certainly a share buyback leader of its industry. This is something we highly appreciate.

Figure 3: AbbVie share buybacks

Source: Gurufocus

The share buybacks should have a positive impact on the share price, as share buybacks increase the ownership proportion per share.

The strategic position of AbbVie together with recent approvals with regards to new products should set the company on a growth path. However, the path of the general stock market is currently highly dependent on the resolution of the coronavirus pandemic.

Our valuation analysis considers three different scenarios for AbbVie for the projected timeline: (i) high-growth period (2020-2024); (ii) convergence to a mature growth (2025-2029); and (iii) a perpetual growth, considering inflation rate and GDP growth.

We used the 10-Year Discounted Free Cash Flow to Shares Model with the following inputs:

FCF to Shares was calculated based on the free cash flow and corresponding shares outstanding in 2019, $12.772 billion and 1.485 billion, respectively, resulting in a ratio of 8.60.

The discount rate was assumed to be Damodaran's average cost of equity from the pharmaceutical industry in the United States.

We have established three different growth rates for our timeline, taking into consideration the resumption of growth described in our catalyst analysis due to the recent developments and the probable and lucrative acquisition deal, which would increase the company's cash flow substantially in the next years.

For the initial five years (2020-2024), we believe AbbVie could perform, at least, equal to the 5-year Damodaran's average net income CAGR from the pharmaceutical industry. Hence, we mixed the global and United States rates in a proportion of 50%/50%, resulting in a high-growth scenario of 6.34%.

From 2025 to 2029, we forecast AbbVie to converge to mature growth. This is partly because industries tend to be more competitive over time, especially for pharmaceuticals. We, therefore, use a growth rate equal to half of the growth from the high-growth scenario, meaning 3.17%. Perpetual growth is set at 2.5%, below global GDP projections to account for a long-run slowdown.

Table 1: Discounted FCF to Shares

Source: HedgeMix Limited

Our valuation model yields a target price of $222. Hence, based on our valuation, the stock is currently trading at a considerable discount.

However, it's important to notice that the current market conditions are extraordinary due to the current coronavirus crisis and that macroeconomic developments will affect the performance of the stock market. Hence, for risk-averse investors, a potential strategy could be to create a market-neutral stock portfolio where you hold a short position in the overall market index of equal size as your primary portfolio. This can be a viable option at the moment.

The rhetoric over potential drug pricing charges poses a legitimate risk associated with investing in pharmaceutical stocks right now. While there is a possibility of the risk materializing, the company is also making strides to ensure that price hikes are maintained within single-digit increments.

While the European Commission has given the green light to the AbbVie-Allergan merger, the US counterparts are still reviewing the possibility of an anti-competition position, and the findings may prolong the integration if other conditions are set.

The pending integration with Allergan certainly also presents unforeseen problems as the two entities are culturally different, which can result in a culture clash. The risks associated with a merger can be overcome by effectively managing the integration and relationship aspects of the merger.

This month came with positive news for AbbVie as the coast is clearer with regards to the pending merger with Allergan (it just received the final EU approval).

The purpose of the acquisition is for AbbVie to ensure that the company diversifies and successfully complements its primary revenue earner Humira with an arsenal of new products. On top of this, we expect powerful synergies in distribution, brand recognition, and market position to prevail.

Currently, AbbVie is heavily reliant on Humira, which accounted for nearly 58% of sales in 2019, and in 2023, it will lose its patent protection. Hence, the timing of the merger would be perfect. A diversified AbbVie has the chance to remain a leader in immunology, and with a solid pipeline of new cancer drugs, it certainly will increase market share in oncology. Venclexta is likely to open avenues for AbbVie as it picks up additional approvals in the treatment of leukemia.

Finally, AbbVie has maintained a robust share buyback strategy, making it a share buyback leader of its industry. This should have a positive impact on the share price, as share buybacks increase the ownership proportion per share.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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