Why Allergan Should Start Paying a Dividend

By Markets Fool.com

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Image source: Getty Images.

Raise your hand if you think big pharma Allergan's (NYSE: AGN)'s recent stock performance has beendismal.(Every hand raised? I thought so.) The company's stockhas dropped 24% this year,while the S&P has gained 4.2%. And that's despite the fact that the company has beaten profit estimates in 10 out of the past 12 quarters, in addition to posting decent earnings last quarter.

I believe I have a solution to this stock's lousy performance, and it's a simple one: Allergan should start paying a dividend to attract more long-term shareholders. My case rests on taking alook into what's really going on with this stock, so let's dive in.

Nothingseems tohelp this stock -- not even a $40 billion windfall

Allergan's earnings last quarter did nothing for the stock,despite some pretty good numbers. In fact, excluding the impact of the loss of exclusivity for its Alzheimer's drug, Namenda, along with a couple of other factors, branded net revenue was up 9% last quarter over the previous year. Add in those missing factors -- currency effects and divestitures -- and revenue was still up 2%. Overall earnings rose 12% sequentially to $3.36 per share, easily surpassing consensus estimates.

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But nothing seems to help Allergan's woebegone stock, includingthe Aug. 2 closing of its $40 billion generics business divestiture to Teva Pharmaceutical Industries LTC (NYSE: TEVA). Despite all the analyst chatter that the sale would never survive U.S. antitrust regulators, it did. And that radically improved Allergan's financial picture. Post-Teva, Allergan's balance sheet shows an impressive $27.6 billion in cash and marketable securities, not to mention a much-improved debt picture. Here's a quick peek at the amazing difference the sale made:

Image source: Allergan investor presentation.

In addition to the great balance sheetimprovement, Allergan recently made a smart acquisition to extend its already powerful eye-care business, spending $95 million for privately held ForSight Vision5 and its novel glaucoma treatment device.

Beyond that, Allergan's pipeline is bearing fruit. The company managed no fewer than three successful new product launches in the first quarter: Viberzi, a treatment for irritable bowel syndrome; Avycaz, a new antibiotic; and Dalvance, an antibacterial for skin infections. Looking forward, it contains new drugs for dry eye, depressive disorder, migraines, and uterine fibroids, not to mention an apparently endless stream of line extensions for top-selling drug Botox into new medical applications.

So why such a dismal performance for this stock?

Too many hedge funds, not enough moms and pops

Blame it on the composition of Allergan's investor base, which is heavily slanted toward so-called "fast money," or hedge fund managers. In fact, late last year, Allergan was No. 1 on Goldman Sachs' ranking of "VIP" stocks that "matter most" to hedge funds. Putting numbers to it, the typical big pharma usually has hedge fund ownership of around 3% or lower. By contrast, hedge funds collectively owned 16% of Allergan at the end of last year.

Hedge funds typically jump in and out of stocks around near-term events and aren't nearly so interested in a company's long-term prospects. So the hedgies abandoned ship when the Pfizer (NYSE: PFE) and Allergan megamerger was called off. In fact, according to FactSet, over $1.5 billion hedge worth of money was pulled out of Allerganlast quarter -- obviously contributing to the stock's downfall.

Now that some of the fast money isgone, let's hope it stays out. On a practical basis, an extreme amount of hedge fund involvement makes a stock unattractive to long-term investors, because the stock's volatility on short-term events naturally raises a certain amount of skepticism.

A dividend would attract long-term investors

With hedge funds exiting, Allergan's investor mix may shift (unless rumors of another big deal bring the fast money jumping back in). So how could Allergan attract those stable investors who are less interested in near-term catalysts and more interested in the company's long-term prospects?

I'm back to my solution -- and now you see how a dividend mightdo the trick.

A dividend is attractive to investors seeking current income, as well as to large and stable mutual funds seeking dividend returns. A dividend also signals to investors and credit ratings agencies alike that the company is confident in its ability to earn profits over the long run.

That's not to say a company's dividends are always an accurate representation of its financial health or liquidity. Companies can pay dividends with borrowed money or other sources of funds than operating cash flow. But that's hardly a problem for Allergan, given the big improvement to itsbalance sheet.

Take a hint fromBotox and turn Allergan into a wrinkle-free stock

Recently, Allergan CEO Brent Saunders has been reaping accoladesfrom the press for making a well-publicized "social contract with patients" on drug pricing. In a company blog, Saunders has vowed that Allergan would raise drug prices no more than once a year and limit them to single-digit percentages slightly above the current rate of inflation.

Of course, we all appreciate Saunders' aim.But the timing makes this is an uncomfortable move for Allergan investors. While the pharma's CEO is making promises to politicians and consumers, his stock has been doing zippo for its shareholders. In addition, investors may well ask how keeping drug prices under such a tight rein could affect Allergan's profitability down the road.

So I have a suggestion for Sanders: Stop focusing on the latest headline-producing bandwagon and start paying your company's shareholders a dividend. It's the one thing that might get your company's dismally performing stock moving upward again.

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Cheryl Swanson owns shares of Allergan. The Motley Fool recommends Teva Pharmaceutical Industries. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.