Allergan plans to complete the $40 billion sale of its generic pharmaceutical business to Teva Pharmaceuticals by the end of May. Following that, Allergan plans to repurchase $4 billion to $5 billion of its stock over the subsequent four to six months. The company also plans to pay down debt with the proceeds of the Teva transaction.
These financial decisions will dramatically affect-and improve-Allergan's appeal to investors-especially now that it has become an undervalued stock. Earnings per share will rise, the price/earnings ratio will fall, debt levels will fall, and the increased earnings growth rate will attract a wider variety of growth stock investment managers.
Recent History of Allergan's Stock Valuation
On October 29, 2015, when the Pfizer-Allergan buyout rumors materialized, I told investors, "AGN is an overvalued stock. Other than the current possibility of a buyout offer, there is no valid reason to expect the stock price to continue to rise until at least 2017. Therefore, if you own AGN, use stop-loss orders to protect your principal while you wait to see if a buyout offer materializes."
Allergan's share price was 311 when I wrote that recommendation. It rose a couple of dollars higher in the coming days, then fell as low as 196 last week-a 37% price drop.
At that time, 2016 earnings per share ( EPS ) were expected to grow just 7%, while the price/earnings ratio (P/E) was 19. My investment philosophy is all about identifying undervalued stocks. My 28 years of stock-investing experience has shown me that I am more likely to outperform the stock market-and lower the volatility of my stock portfolio-by screening out companies with slow earnings growth and high P/Es. Specifically, I want the P/E to be lower than the earnings growth rate; or, in the case of dividend stocks , lower than the earnings growth rate plus the dividend yield.
For example, on October 10, Apple ( AAPL ) was expected to report full-year 2015 EPS growth of 42% (September year-end), but the company's 2016 earnings growth rate was expected to fall to just 7%. The dramatic change in earnings growth caused a big shift in the price action on the stock-a shift that was predicted by my simple investment formula.
Here's my value investing formula:
2016 EPS growth rate + dividend yield > 2016 P/E
Here was AAPL's valuation:
+7% EPS + 1.9% dividend yield
Thus by my measures, AAPL was overvalued. That's why I told investors, "If I owned AAPL, I'd monitor the stock for an opportunity to sell around 122. I'd also put in a stop-loss order at 106, with the intention of raising the stop-loss as the stock price rebounds."
The share price proceeded to rise to a high of 124 on November 4, and has since fallen about 37%.
Allergan's Current Stock Valuation
Allergan's 2016 earnings outlook is modest. Wall Street's consensus earnings estimates show EPS growing 5.5% in 2016 (December year-end). Compared to a 2016 P/E of 15.6, there's no value opportunity in those numbers.
However, next year's numbers are quite interesting. Earnings are expected to grow 22% in 2017, and the stock has a 2017 P/E of 12.8. Allergan is an undervalued stock based on 2017 earnings expectations. (As an aside, the company's debt load is moderate and the stock does not pay a dividend.)
Now that the company has announced a very large share repurchase plan, analysts will increase their EPS estimates for the company. (Simple math: fewer shares outstanding equals increased earnings per share.) Suddenly, Allergan looks like an attractive growth stock!
It's worth noting that in September 2015, Allergan's management set a goal of reaching $25 earnings per share ( EPS ) over the next few years, up from $14 or so this year. Therefore, I have reason to believe that the company's strong earnings growth rate in 2017 will not be a fluke.
What to Expect from Allergan's Share Price
Allergan's stock has been suffering, no doubt. The stock's going to have to stabilize before it can recover to any significant degree. I believe that process has already begun.
If you have any doubt that the worst of the stock's downturn is over, think about it this way: the company is about to purchase b illions of dollars worth of its stock . What makes stock prices go up and down? More buyers than sellers-supply and demand. There's pretty much no chance that anyone will be selling enough shares of Allergan to offset the buying demand that will come from the repurchase authorization.
This stock will be going up for quite a while.
AGN has some upside price resistance around 250, and more around 270. As the stock climbs, expect it to get stuck at those prices, have a pullback and trade sideways for a while before continuing its upward move.
How High Can AGN Climb?
Allergan is expected to earn $17.25 per share in 2017. With an earnings growth rate of 21.7%, we can assume that a P/E of 21.7 would make the stock fairly-valued.
Frankly, the calculation is a little more complicated than that, because it would be influenced by normal industry P/E trends, and Allergan's 2018 earnings outlook. But if we just start with the basics, Allergan's stock will be fairly valued when it reaches 374. That's 72% higher than today's share price.
Am I saying that AGN will reach 374 in 2017? No. I don't have a crystal ball.
What I'm saying is that rough calculations show AGN to be a dramatically undervalued stock.
I'm also saying that, due to the $10 billion repurchase plan, there's very little downside remaining in the share price.
Growth stock investors should feel confident about buying AGN , with the intention of holding the stock for six to 24 months. Make sure you periodically reevaluate its earnings outlook vs. its current P/E.