The following interview was also featured in part on Business Insider
In the aftermath of Brexit, many investors have forgotten about the continuing shakeup in pharmaceuticals. The S&P Pharmaceuticals Select Industry Index has fallen by 28% in the last year, with prominent hedge funds losing particularly big on much-hyped Valeant (VRX:CN). According to SumZero contributors John Dowling and Michael Kon of the Golub Group in San Mateo, this means perfect buying conditions for the Botox and breast implant giant Allergan (AGN:US).
The last few months have been a turbulent period for the Dublin-based company after the U.S. Treasury Department blocked its $160 billion merger with Pfizer. Allergan is now in the final stages of a $40 billion divestiture deal with Israeli-American generics giant Teva (TEVA:US), which, according to Dowling and Kon, creates a buying opportunity for a seemingly troubled Allergan.
SumZero: What about Allergan initially caught your attention as a value investor?
John Dowling, CFA: As value investors, we are constantly looking for bargains. We look for stocks that trade below what we believe is the fair value of the underlying business. To find these ideas you often need to be contrarian, which means focusing on names that others are running away from. Allergan hit our radar screen exactly for that reason. We got interested in it after the stock dropped 25% over a period of several months because sentiment became extremely negative.
Back then, drug pricing was on everyone’s minds and Valeant Pharmaceuticals, which was still changing hands at $150 a share (vs. $22 today), was just beginning to implode. Everyone was comparing Allergan to Valeant, which didn’t make much sense to us so we decided to take a closer look.
SumZero: The market seems to view AGN as another Valeant: a hedge fund hotel with a ton of debt and morally questionable business with steep regulatory risk. Why do you think this is the wrong view?
John Dowling, CFA: It’s true that both Valeant and Allergan have large debt levels built through multiple acquisitions, but this where the similarities end. The business models are completely different. While Valeant is a roll up of numerous unrelated businesses that cover many therapeutic areas including generics and branded drugs, Allergan is focused on only seven of these areas. Valeant’s model was, in our view, predicated on abusive pricing practices that appear to be illegal or at least highly unethical.
The key driver of Allergan’s growth model is actually volume growth, not pricing. Valeant’s management has become notorious for its disdain of research and development spending. Valeant has cut R&D to the bone, which in our view, contributed to some of the volume pressures it’s now facing. Allergan has a much more reasonable approach to R&D, and we are actually very excited about the future growth that its new drug pipeline will yield.
It’s now also very clear that capital allocation at Valeant was lacking, to say the least. Their current dire position and shaky finances are in part due to the company’s multiple large acquisitions at questionable prices. Allergan, on the other hand, has an admirable record on the capital allocation front. We believe that Allergan’s CEO, Brent Saunders, is one of the best capital allocators in the industry.
SumZero: How recession-proof are AGN’s products, many of which (e.g. Botox) are cosmetic?
Michael Kon, CFA: Botox is more sensitive to economic headwinds than most pharmaceutical products. However, if you stop injecting Botox it literally shows on your face, so it’s not really a discretionary treatment. Botox is a must-have treatment for people who feel the need to look sharp all the time. The state of the economy might impact your travel plans, your real estate purchases, or the purchase of personal items, but it has a much smaller impact on the decision to remove wrinkles from one’s face. To some people, it’s almost like shaving, and we typically don’t see more men with beards during a recession. Also, the demand for Allergan’s non-aesthetics products is driven by medical needs. Since these don’t change during a recession the non-aesthetics business of Allergan, just like any other pharma company, is for the most part recession proof.
SumZero: What else is the market missing?
Michael Kon, CFA: We think the market is discounting Allergan’s growth opportunities and the quality of its aesthetics franchise. The Botox business is a wide moat business that is well shielded from competitive threats. Switching costs in that business are fairly high, as are the barriers to entry. The Botox franchise is growing by a healthy clip and is likely to keep expanding over the next five years.
The breast implant business has extremely high market share and operates in a duopoly industry alongside Johnson & Johnson – the firms each have a 40% market share. We also like Allergan’s eye care franchise which is centered around Restasis, a novel treatment for dry eye because it’s the only medication on the market that causes your eyes to naturally produce tear drops. This is Allergan’s largest non-aesthetics franchise and is insulated from competition by patents and manufacturing complexity.
SumZero: Is Allergan still attractive to buy at today’s prices?
John Dowling, CFA: We believe it’s an attractive buy today. We primarily use a DCF model to value our investments, and our model suggests that the stock is worth $262 in our bear case scenario and $342 in the base case scenario. In the best case scenario, the business would be worth as much as $440. The main variable that determines the different scenarios is revenue growth, which depends on the successful execution of Allergan’s drug pipeline. Though it’s hard to predict just how well the pipeline will do, it’s clear that at the current stock price $232, we think investors are paying a price well below intrinsic value.
SumZero: What key metrics should investors be paying attention to as your thesis matures?
Michael Kon, CFA: Our thesis is predominantly contingent upon on the sale of the Actavis generics unit to Teva, so that will be on the top of my list. Beyond that, revenue growth and operating margins are two key variables that we watch very closely.
SumZero: What are the biggest risks associated with the trade in your view?
Michael Kon, CFA: Our position is predicated, in part, on the completion of the Teva deal. Allergan will receive a very good price for this unit and this deal will pay off much of the debt on the balance sheet. Even if the deal fails, our $342 base case fair value estimate would decline by 10% to 15%. This is really a “Heads, I win. Tails, I don’t lose much” situation.
SumZero: The Teva deal’s closing has been delayed for months. How confident are you that the deal will go through successfully? Do you anticipate any more roadblocks?
John Dowling, CFA: We think the probability of the deal closing in the next few weeks is high. Teva has recently announced several divestitures of parts of its business post the Allergan deal, which we think is a strong sign that the Allergan deal closing is imminent.
SumZero: If the Teva deal goes through, what do you think will be Allergan’s best decision in terms of allocating those new funds?
John Dowling, CFA: Allergan already announced that after the deal closes, it will launch a stock buyback. Since the shares are cheap, we think this will be the best use of the funds.
SumZero: Hillary Clinton tweeted on September 21 of last year that she intends to introduce a plan to curtail drug price gouging. That being said, do you think the upcoming election will have a significant impact on the outcome of your thesis?
John Dowling, CFA: We don’t expect the election outcome to have material impact on the business. Most of the aesthetics franchise is cash pay so it probably won’t be subject to any new pricing rules or regulations. The non-aesthetic business might be regulated by new pricing rules, but we don’t think it will change the current level of prices. We looked at Allergan’s past pricing practices and didn’t find any evidence of a behavior that could raise any concerns. Allergan doesn’t gouge payers and we think its prices are fair and reasonable.
SumZero: Since Allergan is headquartered in Dublin, do you think that the Brexit will pose any threats to your position?
John Dowling, CFA: Despite the geographic proximity to the UK, we don’t expect Dublin or Ireland to be impacted in any way that will change our thesis. The tax regime in Ireland is likely to remain the same even if the UK exits the EU.
SumZero: Is this thesis representative of the John Dowling and Golub Group investing style?
John Dowling, CFA: Yes, at the simplest level we want to invest in companies with solid competitive advantages, run by managements that are great business operators but also sound capital allocators, and at a price that makes sense in relation to the future economics of the business. In the most compelling sort of situation, you have a business that has one-time, solvable problems that, once rectified, will result in a recovery in EPS and a trading multiple re-evaluation by the market. We believe that Allergan represents such a scenario given that investors are: (1) disappointed over the failed tax inversion deal with Pfizer; (2) experiencing uncertainty regarding the generics sales to Teva, which we think will eventually be completed; and (3) irrationally believing that Allergan’s business practices are similar to Valeant’s.
SumZero: Where else do you see value in the market today?
John Dowling, CFA: We see quite a bit of value in financials. While not the typical compounding machines that we look for, a select group of quality banks are trading substantially below intrinsic value. In the short term, these stocks fluctuate based on the Fed’s interest rate policy decisions. Over the medium- to long-term say the next five to ten years, there is a good possibility that interest rates will go higher, especially if we start to see some inflation. If that occurs, there’s substantial upside in the financial names, although higher rates are not necessary to make money in these investments. We're happy to own them at a steep discount to liquidation value while the management teams continue to buy back shares in the low rate environment. Everyone is focused on the threat of central banks’ Negative Interest Rate Policies, but anybody who has observed history will tell you that interest rates are very difficult to predict. Even if rates remain subdued, the managements will keep buying back stock, and we should achieve a decent return just from the annual increase in book value.
We also like some industrial names that were impacted by the collapse of the energy sector, particularly Flowserve, which sells pumps and valves predominantly to downstream and midstream O&G segments, but also to end-markets other than energy. The company has seen its revenue decline as customers cut their capital expenditures and are deferring maintenance. But since a substantial portion of their revenue comes from aftermarket sales we think the market doesn’t give enough credit to the resilience of the business. We also like Grainger at current prices. The company faces severe headwinds in the energy space and cannot grow in the current environment, partially due to very weak economic conditions in Canada and in the U.S oil patch. Long term, we think Grainger has terrific opportunity to grow top line, mainly by expanding its presence in the small business space through online sales. In fact, the company recently disclosed that its online sales have reached $1B and are growing 30% per annum.
SumZero: How has your approach evolved over the years?
John Dowling, CFA: I was fortunate to get exposed to the core concepts of value investing early in my career. The idea of Margin of Safety and the notion that the stock market is there to serve you, rather than guide you, has always been part of my approach. What evolved over the years was my knowledge base. As you research more and more companies and look at new industries you start to recognize patterns and gain greater context for understanding investment opportunities. In addition, my portfolio management skills have evolved. It’s one thing to determine that a stock is undervalued, but it requires another set of other skills to decide upon the size of the position, and the precise entry and exit point. There are a lot of factors that go into sizing a name, including assessing the business’s quality, complexity, cyclicality, the size of the Margin of Safety, opportunity cost from other investments, etc.
SumZero: Tell me about your investing background and investing mentors and heroes.
John Dowling, CFA: My career began in 1998 at PricewaterhouseCoopers where I served a consultant for clients looking to transact in the market for privately-owned businesses. As a generalist analyst I was afforded the opportunity to research a variety of different industries and hone my valuation skills, but my real passion was to become a buy-side analyst, a role in which there are direct consequences, either favorable or unfavorable, for your decisions. I was fortunate to land a position at Peters MacGregor Capital Management, a value-investment shop whose investment philosophy closely mirrored my own. I worked there for two plus years before joining up with Golub Group ten years ago.
In terms of my mentors, as is typically the case with many value investors, Buffett has been my biggest influence. What’s interesting about Buffett is that he’s really a synthesis of so many great investors that came before him. If you’ve read books like Phil Fisher’s “Uncommon Stocks and Uncommon Profits” or Adam Smith’s “The Money Game”, you’ll notice that when Buffett speaks he’s often making direct quotes from these books. It was rumored that when Buffett met David Dodd, the co-author of “Security Analysis”, Mr. Dodd was stunned to learn that Buffett knew more about the investing examples in the book than Dodd did himself! Point being, if you read Buffett, you’re in essence, learning from all the giants whose shoulders he’s stood on.
SumZero: What advice would you give to someone interested in pursuing investing?
John Dowling, CFA: I would encourage anyone interested in investing to begin early and read voraciously, starting with books about investors who have been highly successful. If you want to learn how to hit a great forehand in tennis, you’ll want to watch Roger Federer. Likewise, if you want to become a great investor, you’ll want to read Buffett, Graham, Lynch, etc.
Delving into books that explain the fundamentals of each industry and reading annual reports on publicly-traded companies is also imperative. Additionally, you need a sound understanding of accounting because, as Charlie Munger says, “accounting is the language of business.” A good way to establish this understanding in accounting, and more generally across all finance, is to complete the CFA Certification. I’d also recommend interviewing at investment firms that have a rotational program where one can spend time looking at various different industries. Lastly, I’d say don’t get too overwhelmed by all the work that goes into becoming a great investor. Take your time and enjoy the learning process.