Wednesday, April 20, 2016

Valeant: Information Vacuums, Management Credibility and Investment Value

As an investor, would you buy shares in a company that is at the center of a political and legal firestorm? What if this company has a CEO who has lost the faith of his board and an ex-CFO who is being accused of shady financial practices? And would you pull  the buy trigger if the company has delayed its scheduled annual filing by more than two months, and by doing so is running the risk of violating debt covenants and being pushed into default? And to top it all off, would you be a little worried  if the largest investor in the stock, a well known activist with his reputation and wealth on the line, is now calling the shots? No way, you say! At the right price, I would, and that is the reason that I decided to revisit my Valeant valuation last week, six months after I valued it for the first time, in the aftermath of a crisis born of hubris and happenstance. In structuring this post, I will draw on an old-time consulting matrix, where companies were classified into stars, cash cows, dogs and question marks, to illustrate the transience of these classifications, since Valeant has cycled through the entire matrix in a year.

Valeant, the Star
Valeant's rise from an obscure Canadian drug company to pharmaceutical star has been well chronicled and rather than drown you in prose, I think it is best captured in this picture, which shows the increase in market value (market cap and enterprise value) and operating numbers (revenues and operating income), especially between 2009 and 2015:
Source: S&P Capital IQ
During a period when other pharmaceutical companies were struggling with revenue growth and profit margins, Valeant outstripped them on both counts, growing revenues at almost 43% a year while posting higher operating profit margins than the rest of the sector. At least on the surface, the company seemed to be delivering the best of all combinations: high growth with high profitability.

So, how did Valeant pull of this feat? In an earlier post on the company, in November 2015, I argued that the Valeant business model was a stool with three legs: growth from acquisitions, with the acquisitions funded primarily with debt, followed by a strategy of increasing prices on "under priced" drugs.

The unique combination of growth and profitability made the company a target for value investors, making it a favored stop for investors as diverse as Bill Ackman, the activist investor, and the Sequoia Fund, a storied mutual fund, and a dominant part of their portfolios. In their defense, not only were these investors transparent about their big bets on Valeant, but at least until September 2015, their concentration was viewed as a strength rather than a weakness. In fact, when I posted on why diversification is a necessary component of even a value investing strategy, it was these two investors that were held up as a counters to my argument.

To see the allure of Valeant to value investors, let me go back to mid-year last year, when the company's business model was going strong, its stock price was higher than $200/share and its enterprise value exceeded $100 billion. If the intrinsic value of a company is driven by cash flows from existing assets, value-creating growth and low risk, Valeant looked attractive on almost every dimension:

Valeant was not only delivering the value trifecta, high revenue growth in conjunction with high operating profit margins and generous excess returns, but was doing so on steroids (taking the form of low taxes and high debt). One note of caution even then, though, was that the business model was built on an architecture of acquisitions, with acquisition accounting playing a large role in pushing up operating profitability and lowering taxes.  If you were unfazed by the acquisition accounting effect and assumed that the company could continue to deliver this combination going forward, the value per share that you would have obtained for the company would have been more than $200/share. 
Download spreadsheet
In estimating the value, I did lower the compounded revenue growth for Valeant to 12% for the next ten years, but that translates into revenues more than tripling over the decade. 

From Star to Cash Cow
While many trace Valeant's fall to September and October of 2015, when short sellers launched an assault on its links to Philidor, an online pharmacy, the business model was already under pressure in the months prior, a victim of its own financial success. The model was designed, in my view, to operate under the radar, since key parts of it (the drug pricing and acquisition accounting) would wither under exposure. While much of what Valeant did in 2010 and 2011, when the company was not a household name, went unnoticed, its actions in 2015, when it was a higher profile company, drew attention from unwelcome sources. The company's acquisition of Salix increased the scrutiny, both because of it's size and partly because the Salix drugs that Valeant acquired (and repriced) affected more people (and drew more complaints). The Philidor revelations pushed these concerns into hyperdrive and the stock lost almost 55% of its value in September and October, dropping from $180/share to $80/share.

In my November post, I rehashed much of this story and argued that even if Valeant were able to survive legal and regulatory scrutiny, the company would never be able to return to its old business model. In effect, even in the absence of more bad news, Valeant would have to be run like other pharmaceutical companies, reliant on R&D, rather than acquisitions, for (more anemic) growth. Removing the debt-funded acquisitions and the drug repricing  from the business model yielded a company with lower revenue growth (3% a year, rather than 12%), lower margins (a pre-tax operating margin of 43.66%, instead of 49.82%) and higher taxes (with an effective tax rate of 20% replacing 16.51%).

Download spreadsheet

Note that these numbers were reflective of more conventional drug companies and reflect a profitable, albeit slow-growth business. With these numbers, though, the value per share that I obtained for Valeant was about $77, down substantially from its star status, but the market price, at $82, was higher. 

From Cash Cow to Dog?
If there were dark clouds on the horizon for Valeant in November 2015, the months since have only made them darker for four reasons:
  1. Information blackout: In November 2015, when I valued Valeant, I used the most recent financial filings of the company, from October 2015,  to update my numbers. Almost six months later, there have been no financial filings since, and the 10K that was expected to be filing in February 2016 was delayed, ostensibly because the company was still gathering information, and that delay has extended into April. 
  2. Managerial Double talk: In the intervening months, Valeant’s managers have been in the news, almost as often giving testimony to Congress, as holding press conferences. Arguing, as they did, that they grew through R&D like any other pharmaceutical company and that their revenue increases came mostly from volume growth (rather than price increases) was so much at odds with the facts that they became less credible with each iteration. Michael Pearson’s hospitalization for an undisclosed illness, just before Christmas, was something that was out of the company’s control but its handling added to the air of opacity around the company. 
  3. Legal Jeopardy: The Philidor entanglement, the original source of the crisis, did not go away. In fact, the company, after claiming that separation from Philidor would be low-cost and easy backtracked in January and February with disclosures that suggested deeper links, with the potential for legal problems down the road. 
  4. Debt load: Debt is a double edged sword, increasing earnings per share and providing tax benefits in good times but potentially making bad times worse. That argument got backing from what happened at Valeant, a company that accumulated more than $30 billion in debt during its acquisition binges, with about half of that debt being added on during 2015. That debt came with the added covenant that if financial disclosures were not filed by March 30, 2015, the firm could technically be in default, a possibility that spooked markets. 
Without financial disclosures from the company, a management that seemed to be making up stuff as it went along and the possibility of a debt covenant being triggered, it is not surprising that the market marked down Valeant’s stock price further:


This price collapse, following last year’s swoon, has reduced the market capitalization of the company to $11 billion, almost 85% lower than its value a year prior. In late March 2016, the company announced that Michael Pearson would be stepping down as CEO, the clearest sign yet that there will no return to the old business model, and Bill Ackman increased his involvement of the company in a bid to preserve what was left of his investment in the company and more importantly, his reputation as a savvy activist investor.

With the stock trading at $32, the question of whether the stock is a good buy now looms large. Compared to my November 2015 estimate, the answer is an emphatic yes, but the caveat is that a great deal has happened to the company’s fundamentals during the last six months that could have shifted the value down significantly. The problem that I face, like any other investor in Valeant, is that in the absence of financial filings, there are no numbers to update. The solution seems simple. Wait for the delayed filing to come out in late April, early May or later, and use that updated information in my valuation. That is the low-risk option, but I think that it is also a low return option, since if the filing contains good news (that revenues have held up and profit margins remain healthy), the stock price will adjust before my valuation does. The alternative is scary, but it has a bigger payoff. I could try to make a judgment on Valeant’s value now, before the information comes out, and follow through by buying or selling the stock. In arriving at this value, here are some of the adjustments that I chose to make:
  1. The Dark Side of Debt: The debt at Valeant has become more burden than a help, as it has not only triggered worries about covenants being violated but has opened up the possibility that that the company will have trouble making its payments. In fact, Moody's lowered the bond rating for Valeant to B1, well below investment grade, in March 2016, causing an increase in the cost of capital used in the valuation from 7.52% (in my November 2016 valuation) to 8.29%. The secondary impact is that there is a chance now that Valeant's going concern status may be jeopardized by its debt commitments; I assume a 5% chance of this occurrence in conjunction with the assumption that a forced liquidation of its assets will come at a discount of 25% on fair value. 
  2. The Bad News in Delay: Delayed news is almost never good news and there are two key operating numbers where the delayed report can contain bad news. The first is that the company may restate revenues, reflecting its separation from Philidor and perhaps for other undisclosed reasons. The second is that the company may reveal that some or all its acquisition-related expensing from prior years may have been overdone, resulting in some or a big chunk of these expenses being moved back into the operating expense column. In my valuation, I will assume (and cheerfully admit that this is based on no news) that the revenue reduction will be small (about 2%) and that half of all acquisition expenses will be shifted to operating expenses, reducing the pre-tax operating margin to 40.39% (from the 43.66% that I used in November 2015). 
Since I had already assumed that the existing business model was dead in my November 2015 valuation, I don't see any need to lower revenue growth further or to raise the effective tax rate. The value that I obtain with these updated numbers is below:
Download spreadsheet
The value per share that I obtain for Valeant is $43.66, higher than the stock price ($32) at the time of this analysis. That value, though, is clearly a bet on what the delayed financials will deliver as a surprise. One way to measure the exposure that you have to this risk is to measure value as a function of how much of a revenue and earnings surprise you get from the report:

Is there a chance that the earnings report could contain news that make Valeant a bad investment at $32? Of course, and you will have to make your own judgment on that possibility, but based upon my priors (uninformed though they might be), it looked like a good investment at $32, late last week, and I own it now. 

Conclusion
I am sure that Valeant will be used to draw many lessons and I will extract my share in future posts about acquisition accounting, activist investing and corporate finance. The first is that acquisition accounting is rife with inconsistencies and plays into investor biases and preconceptions about companies. The second is that cookbook corporate finance, with its dependence on metrics and magic bullets, can have disastrous consequences when it overwhelms the narrative. The third is that activist investing, notwithstanding its successes, has two weak links: concentrated portfolios and investors who can become too wedded to their investment thesis.   I will continue to draw on Valeant as an illustrative example of how quickly views on a company and its business model can change in markets and why absolutism in investing (where you know with certainty that a business model is great or awful, that a stock is cheap or expensive) is an invitation for a market takedown. 

YouTube Video


Attachments
  1. Value of Valeant as Star (September 2015)
  2. Value of Valeant as Cash Cow (November 2015)
  3. Value of Valeant as Dog (April 2016)
 

30 comments:

Anonymous said...

I've been valuing companies for 10 years now. I always keep coming back to the book "A Random Walk Down Wall St." Yes, somebody has to value companies, and all valuations are based on the future (because nobody buys the past), but the truth is that none of us truly knows the future - not even our best and brightest industry leaders. Everything we do as valuators should come with a stamp "It depends."

Anonymous said...

Thank you sir for wonderful analysis.

Please do similar research on Ricoh India stock value which is facing almost similar crisis.

No results for last 9 months. CEO was ousted. Stock price has fallen drastically.

Rishi Ajmera said...

There is something to be said about being wary of companies that haven't displayed the best judgement. Essentially the Warren Buffet school of thought of investing in a solid company at a fair valuation, versus a subpar company at a discount. Would love to hear your thoughts on this mindset and the Valeant case.

Anonymous said...

Nice Article.

What I am struggling with is where has the ~$10 B in cash flow they reported from 2012 to 2015 gone?

I estimate that since 2008 they have made ~$31 B in cash acquisitions and grown debt to ~$32 B. With less than $1.0 B in cash left it looks like debt pretty much equals acquisitions. They haven't repurchased stock and only paid a one time dividend of ~$1.5 in 2010 as part of the Biovail merger. So where did the rest of the cash go? I can see some cash needed for CapEx and Working Capital but not ~$10.0 B.

Any thoughts?

cordura21 said...

It gives me the shivers that such talented investors as Sequoia, with a great track record and a defensive attitude, was hurt in this situation. They said that Valeant was like a cigar butt investor in underpriced drugs. How did that happen? And how did Munger had such a prescient and spot in view on Valeant, while other very intelligent investors fell into the trap ?

The Shadow Banker said...

I too was wondering if at this price Valeant might be a buy. Then I read Nathan Vardi's recent article on the company in Forbes where he outlines how out of control Mike Pearson's personal life was the last few years. This worries me to the extent that not only did Pearson overpay for acquisitions, but that he greatly did so. Thus there's much greater risk that the cash flows the company generates going forward will not be enough to cover the interest expense from all the debt he racked up on these acquisitions, leading to a higher probability of a zero.

http://theshadowbanker.org/2016/01/11/letter-bill-ackman/

mike said...

Thanks for all the good posts over the years and for sharing your thought process also.

Good luck on this investment :) Would love to hear your assessment of probability of bad news ;) (mine is pretty high.)

Anonymous said...

In your 2015 analysis, why would you tax effect the debt rate, and then adjust the income tax rate to 20%? Is it due the presence of the ongoing tax benefits from questionable accounting choices being carried forward?

Anonymous said...

I enjoyed reading your article. I do believe that selling a core asset ie Baush&laumb will ruin their valuation and I do not believe that bondholders will force them to. My estimate for Valeant Pharmaceuticals is high forties this year and sixty to eighty in two years. Thank u Steven Larry Kaye Esq Kaye Kaye

Anonymous said...

I still believe Valeantcan sell other assets then relinquish their best asset it is committing financial suicide if u are correct and they unload it.

Anonymous said...

Selling baush&laumb should be only if bondholdes force it

Aswath Damodaran said...

Rishi,
If my only investments are solid companies at fair valuations, why not just buy an index fund? The Warren Buffet school argues for buying solid, safe companies at significant discounts on value, and if I do find them, I will buy them. I just think that the odds are very low of finding such an investment and the ones that you find (like IBM) turn out to be value traps.
Anonymous,
What is this fixation on B&L? My valuation is not predicated on them selling any pieces of Valeant. The only reason B&L becomes a factor is if default looms, it is a relatively liquid piece of the company that can bring in lots of cash and be used to pay down debt.

Van Kirchhoff said...

Professor,

My limited understanding of acquisition cost accounting tells me that costs to register debt and securities can still be capitalized but acquisition costs such as legal and other professional fees need to be entered as an expense. Can you give any more details on your estimate that 50% of Valeant's past acquisition costs will be reclassified?

Sincerely,
Van

Rishi Ajmera said...
This comment has been removed by the author.
anant.bk said...

"Debt is a double edged sword, increasing earnings per share and providing tax benefits in good times"

I Understand debt should negatively effect EPS

Jack Candley said...

Fantastic reading as always. Loved the way you demonstrated your valuation, totally made sense. Here's another good one which has been making the rounds at my office, it focuses more on the qualitative side: http://halfmillion.com/valeant/

realist said...

Professor, thank you for the thoughtful analysis. It's an interesting read.

My biggest question is how you've gotten comfortable with the assumption of a 3% CAGR going forward and that Valeant in its current form isn't just a melting ice cube. Health care distortions obviously aren't going to go away overnight, if ever. Valeant, however, looks to have pushed these distortions past the breaking point. The result appears to be that PBM's are now highly motivated to put all Valeant products under a microscope in their formulary and pricing decisions. The PBM's also now have a lot of PR and political leeway to do just that. The reports I've seen are that many of Valeant's products won't hold up to this scrutiny and will therefore face significant cuts in price and volume. And, of course, Valeant isn't R&D driven so there's not a robust pipeline of new produts to drive future growth.

I admittedly haven't quantified this impact on revenue and operating income. Presumably taking a detailed look product by product would be the best way to get at least a reasonable estimate of the impact. I do see one hint in Valeant's deal with Walgreens, however - http://www.reuters.com/article/us-valeant-pricing-walgreens-boots-idUSKBN0TY1N120151215 . My read of this report is that Valeant is reducing the price of the impacted dermatology and opthomology drugs by 50% on a weighted average basis, with a $600 million reduction to revenue and operating income. So this one deal alone is a greater than 10% hit to operating income. And, from what I've read, at least one of these products is still highly overpriced relative to its efficacy and competitors. That's Jublia, after a 10% cut in its wholesale price.

In short, I think that a base case of 3% growth is highly optimistic and that your downside case of a 20% drop in operating income followed by 0% growth may not be nearly draconian enough.

Aswath Damodaran said...

Anant,
I am not sure where you are going with your comment, but your starting premise is wrong. Debt positively affects EPS.
Jack,
I did read the half million piece and I think does a very effective job marshaling a case against Valeant. It does mix in too much of the past (we all agree that Valeant played accounting games with acquisitions and that its drug repricing strategy is dead) but at this point, this (and any discussions about Pearson's missteps) are behind us. The question is whether there is enough left in the company's tank to make it worth more and I think there is.
Van,
The acquisition expenses are shown as expenses but they are separated from operating expenses, leaving the impression that they are transient. Analysts followed the cue by adding back these expenses to income to arrive at sustainable income. The fault lies as much with analysts as it does with the company.
Steven,
We can debate whether selling a business is good or bad, but at the right price (say $20 billion), Valeant may be better served with the cash. That option would make the most sense if the debt claims get closer but the fact that Valeant has this option is one reason that I bought the stock.

Anonymous said...

Thanks for the insightful analysis. My concern is cost of debt used at 6% seems Low. Even if the news on earnings / financials is neutral to surprise. I would think refiancing will cost more than 6%., even CDS trading at close to 7%. At those levels stock trades around current level of $ 35 and limits near term upside of $43 that you have. Keen to get your thoughts. Thanks.

Aswath Damodaran said...

A couple of you have pointed to my cost of debt being too low. I based it on their bond rating rather than what the bonds are trading at right now and here is my rationale. One reason that Valeant bonds are down (and the interest rates on them are up) is the same one that is pushing stock prices down. In my narrative, the earnings report will contain bad news (translating into my revenue drop and lower operating margin), but if that is the extent of the bad news, the bonds will recover as well. It is possible that my entire narrative is too optimistic, but it is what I believe..

Anonymous said...

Thank you for the prompt response. Given the baggage and history on this, debt and new debt may want to reprice because upside for them is limited, unlike equity. At least until financials, new operating model and management prove themselves again. What do you think. Thanks.

Van Kirchhoff said...

Professor,

Now that the 10k has been released I'm sure everyone is looking forward to your next update. I'm looking for anything dealing with acquisition expenses in the 10k right now. Thank you for your replies.

Elliott said...

Dear Aswath

Thank you for this amazing analysis. I wondered, should the "Value of this growth" you record in cell B35 not also subtract debt and add back cash?

Kind regards

Elliott

Anonymous said...

Any update based on what you saw in the published 10K report?

Michael Urriola said...

I would love to see your analysis on the 10k filed today.

Michael Urriola said...
This comment has been removed by the author.
Anonymous said...

Great analysis and interesting model. You are not optimistic but will be interesting to see how price follows (or not) the valuation. Looking forward to your update following 10-k.

vivek said...

Sir can you provide an update on this, 10-K is out and Q1 guidance is restated ?

Anonymous said...

Very interesting, thank you.

Since your valuation is around $44 and the recent runup caused by

"S&P Lifts Outlook on Valeant Pharma (VRX) to Positive; Sees Lower Risk of Near-Term Default"

brought the stock at 38 from 29, did you resist the temptation to sell at 38 or did you bail out ?
Considering right now the stock is at 26, no one could argue against that.

The 10K has been released and while the revenue kept up, operating expenses shoot higher, as you were suspecting.

Any comment about where things stands now in your view ?

Thanks.

Lee Tourist said...

Prof. Damodaran,
I enjoyed your podcast with Ritholtz.
Do you have an updated view re Valeant? The stock is well below $18 today Oct 31.
Thanks.