Allergan’s (AGN) Q2 results appeared to be pretty strong, at least on the surface.  The company reported revenue of $4.0 billion and EBITDA of $1.6 billion. Revenue and EBITDA grew Y/Y by 9% and 13%, respectively. Revenue from U.S. Specialized Therapeutics, and International both grew by double-digits. Their growth was offset by a 1% decline in U.S. General Medicine.    

All of the growth was not organic, however. U.S. Therapeutics grew revenue via acquisitions – it acquired and growth in key brands like Botox, offset by reductions in Restasis (chronic dry eye) and Aczone (treats acne). Generics suffered from a loss of exclusivity for Asacol HD (ulcerative colitis) and Minastrin (birth control), in addition to a decline in Namenda XR (Alheimer’s).

Despite double-digit growth in both revenue and EBITDA, Allergan’s growth is dead for the following reasons:

Lack Of Investment In Generics

Like Valeant (VRX) and Mallinckrodt (MNK), Allergan has grown its pharma operations through acquisition. The playbook has been to acquire companies to show growth in the top line, and then cut R&D and SG&A expenses to demonstrate to show growth in the bottom line. The scheme works as long as the acquirer keeps rolling up more companies. Once acquisitions subside you are left with stagnant to declining top line growth and no R&D machine to create new products.

During the quarter Allergan’s EBITDA expanded via cost-cutting. Sales and marketing expenses were 23% of revenue, down from 24% in the year earlier period. On a dollar basis sales and marketing expenses were $884 million, up from $827 million in the year earlier period. However, generics’ sales and marketing costs were $288 million, down from $332 million in the year earlier period. While sales and marketing for the entire company rose $57 million Y/Y, such costs were reduced within generics by $44 million.

R&D as a percentage of revenue was 17%, down from 24% in the year earlier period. On a dollar basis the company’s $489 million in R&D costs were down $147 million Y/Y. The reduction in R&D could hamper Allergan’s ability to produce new drugs and grow revenue organically. The declining investment in generics (37% of total revenue, 35% of total contribution margin) could hasten its continued decline in the future.

Growth Via Acquisition Could Become Constrained

Financial markets continue to set record highs. Markets have been buoyed by an accommodative Fed and expected economic stimulus from President Trump. Frothy valuations make it difficult to generate acceptable returns from acquisitions. In February Allergan acquired Zeltiq Aesthetics, a medical technology company that develops and markets products utilizing its proprietary controlled cool sculpting technology. Its CoolSculpting system helps reduce fat through a natural biological process called apoptosis.

The $2.4 billion purchase price equated to approximately 6.8x Zeltiq’s revenue and 142x EBITDA. Allergan currently trades at just over 15x EBITDA; tucked within Allergan, Zeltiq’s earnings are now valued by the market at far less than the Allergan deal suggested. It might behoove Allergan to tamp down acquisitions in the near term until valuations become less frothy.

Allergan Could Become Constrained By Debt

Allergan has a debt load of about $30 billion. Management estimates its debt-to-adjusted EBITDA is 4.0x. Moody’s currently rates the company’s debt at Baa3 – lower medium grade. If debt-to-adjusted EBITDA exceeds 4.0x for a sustainable period then it Allergan could suffer a downgrade to junk status. That said, it could be constrained from making future acquisitions or lack the financial flexibility for other ventures such ventures hurt its credit metrics.