Tuesday, November 22, 2016

Faith, Feedback and Fear: Ready for the Valeant Test?

It is easier and more fun to write about your winners than your losers, but it is also far more important and valuable to revisit your losers, where the story has not played out the way you hoped it would. It is important because it is easy to lapse into denial and hold on to your losers too long, not only because you let hope override good sense but also because the act of selling is the ultimate admission that you made a mistake. It is valuable because you can learn from these mistakes, if you can set aside pride and preconceptions. So, it is with mixed feelings that I am returning to Valeant, a stock that I bought in May at $27, contending that it was worth $44, but where the market has clearly had other ideas. 

Valeant: Revisiting the Past
I first wrote about Valeant just over a year ago, when it was entering its dark phase, surrounded by scandals, management intrigue and operating problems. At the time, the stock had completed a very quick descent from market star to problem child, with its stock price (market cap) dropping from $180 on October 1, 2015 to $80 on November 6, 2015. While there were many in the value investing community, where it had been a long time favorite, who felt that the market had over reacted, my valuation of $77 left me just short of the market price of $80 at the time. Over the next few months, things went from bad to worse on almost every dimension. The management team disintegrated, with many of the top players leaving in disgrace, and the company held back on reporting its financials because it was having trouble getting its books in order, never a good sign for investors. Testimony by its top managers in front of congressional committee shredded its corporate character and the company faced legal challenges on multiple fronts. The market, not surprisingly, punished the stock as the company lurched from one crisis to another and the stock price dropped almost 75%:

In May 2016, I revisited the company, just after it hired a new CEO (Joseph Papa) and Bill Ackman, a long-time activist investor in the company, decided to take a more active role in the company. In revaluing the company, I noted that the missteps at the company had hamstrung it to the point that it had during the period of a year made the transition from Valeant the Star to Valeant the Dog. The value that I estimated for the company, viewed as such, was $43.56.

Download spreadsheet
In keeping with my theme that the value of a company always comes from an underlying story, it is worth being explicit about the story that I was telling in this valuation. In May 2016, I viewed Valeant as a mature pharmaceutical company that would not only never be able to go back to its “acquisitive” days but was likely to lose ground to other pharmaceutical companies with better R&D models. Consequently, in my valuation, I assumed low revenue growth and lower margins and a return on capital that would converge on the cost of capital over time. My decision in May 2016 was to buy Valeant at $27 because I felt that, notwithstanding the fog of missing information, management changes and legal sanctions, the company was a good buy. 

The Market Speaks
In the months since my buy in May 2015, there has been little to cheer about for Valeant investors. The stock had an extended swoon in late June, recovered somewhat in August, before continuing its descent in the last two months, with three possible explanations for the price performance. One is that the debt overhang, with $30 billion plus in debt due, making it the most highly levered company in the pharmaceutical business, creates market spasms each time worries about default resurface. In fact, every few weeks, another rumor surfaces of Valeant planning to sell a major chunk of itself (Bausch and Lomb, Salix) to remove the debt burden. The second is that the consolidation and cleaning up for past mistakes seems to be taking a lot longer than expected, with revenues stagnating and huge impairment charges pushing equity earnings into negative territory. The third is that the legal jeopardy that was triggered by the events of last year is showing no signs of abating, with the most recent news story about indictment of Valeant executive, Gary Tanner, and Philidor's Andrew Davenport  continuing the drip-drip of bad news on this front.

For most of the last few months, as the price dropped, I have been waiting for something more concrete to emerge, so that I could revalue the company. On November 8, Valeant filed its most recent earnings report for the third quarter, reporting that revenues were down more for the third quarter of 2016 and larger losses than expected. It accompanied the report with forward guidance that suggested continued stagnation in revenues and no quick profit recovery next year, leading to a sell-off in the stock, pushing the price down to just below $14 on November 9. While I the reports is definitely not good news, I must confess that I did not see much in that report that was game or story changing. To see why, take a look at the numbers contained in the most recent earnings report:
2016, Q32015, Q3Change2016, Q1-32015, Q1-3Change
Revenues$2,480 $2,787 -11.02%$7,271 $7,689 -5.44%
COGS$658 $649 1.39%$1,946 $1,855 4.91%
S,G &A$661 $698 -5.30%$2,145 $1,957 9.61%
R&D$101 $102 -0.98%$328 $239 37.24%
Amort & Impair, finite-lived intangible assets$807 $679 18.85%$2,389 $1,630 46.56%
Goodwill Impairment$1,049 $- NA$1,049 $- NA
Acquisiton Costs (all)$67 $213 -63.93%$131 $648 -65.06%
Operating Income$(863)$448 -292.63%$(716)$1,366 -152.42%
EBIT pre-acquisition costs$(796)$661 -220.42%$(585)$2,014 -129.05%
EBITDA$1,060 $1,340 -20.90%$2,853 $3,644 -21.71%
EBITDAR$1,161 $1,442 -19.49%$3,181 $3,883 -18.08%

It is true that the company is delivering lower revenues than the revenues that I had forecast for the company in May 2016 and it is also true that the company’s profit margins are dropping. However, and this may just be my confirmation bias speaking, as I look at the third quarter numbers, it seems like a significant portion the bad news reported for the quarter reflects repentance for past sins, not fresh transgressions. The company has had to respond to its “price gouger” reputation by showing restraint on further price increases (dampening revenue growth in its drug business) and the losses in the third quarter can be largely attributed to impairments of goodwill and assets acquired during the go-go days. In the table below, I break down the drop in operating income of $2.08 billion from the first 3 quarters of 2015 to the first 3 quarters of 2016 into it's constituent parts: 
Effect on operating Income% Effect
Declining Revenues$(317)15.27%
Change in Gross Margin$(192)9.24%
Change in SG&A$(188)9.05%
Change in R&D$(89)4.29%
Change in Acquisition Costs$517 -24.89%
Change in Amortization (Assets + Goodwill)$(1,808)87.05%
Change in Operating Income, , First 3Q 2016 vs First 3Q 2015$(2,077)100.00%
The numbers suggest that almost 87% of the decline in operating income can be traced to amortization either of finite lived assets or goodwill, though there has been deterioration in the business model as manifested in the decline in sales and gross margins. It is for this reason that the effect this earnings report has had on my “Valeant as Dog” story is muted, largely because the story was not an uplifting one in the first place. My updated version of the story is that Valeant is not that different from my old one (of slow growth and lower margins) with tweaks for an upfront adjustment period where revenues are flat and margins worse than the past, as the company continues to slowly put its past behind it. The value per share that I get with this story is $32.50 and the picture is below:
On November 8, 2016, with the stock price at about $15, it was the biggest loser in my portfolio but if I trust my own updated assessment of value of Valiant, it is now more undervalued (on a percent basis) than it was in May 2016. 

Faith and Feedback
In both my valuation and investments classes, I spend a significant amount of time talking about faith and feedback and how they affect investing.
  1. Faith: As an investor, you are acting on faith when you invest, faith in your assessment of value and faith that the market price will move towards that value. If you have no faith in your value, you will find yourself constantly revisiting your valuation, if the market moves in the wrong direction (the one that you did not predict) and tweaking your numbers until your value converges on the price. If you have no faith in markets, you will not have the stomach to stay with your position if the market moves against you. 
  2. Feedback: As an investor, you have to be open to feedback, i.e., accept that your story (and valuation) are wrong and that market movements in the wrong direction are a signal that you should be revisiting your valuation. 
I view my investing challenge as maintaining a balance between faith and feedback since too much of one at the expense of the other can be dangerous. Faith without feedback can lead to doubling down or tripling down on your initial investment bet, blind to both new information and your own oversights, and that righteous pathway can lead to investment hell. Feedback without faith will cause an endless loop where market price changes lead you to revisit and change your value and your holding period will be measured in days and weeks instead of months or years.  Stocks like Valeant are an acid test of my balancing act. There is a part of me that is telling me that it is time to listen to the market, take my losses and sell the stock. However, doing that would be a direct contradiction of my investment philosophy and I am not quite ready to abandon it yet. The second is to avoid all mention of the stock and hope that the market corrects on its own, but denial is neither faith nor feedback. The third is to accept the fact that I did underestimate how long it would take Valeant to put its past behind it and to revalue the company with my updated story and that is what I tried to do. That acceptance of feedback, though, has to be accompanied by an affirmation of faith; since it led me to buy the stock at $27, when my estimated value was $43 in May 2016, it should lead me to buy even more at $15, with my estimated value at $32.50. So, I doubled my Valeant holdings, well aware of the many dangers that I face: that the operating decline that you saw in the third quarter of 2016 will continue in the future years, that the debt load will become more painful if interest rates rise and that the recent indictments of executives will expose the firm to more legal jeopardy. If the essence of risk is best captured with the Chinese symbol for crisis, which is a combination of the symbols for danger and opportunity, Valeant would be a perfect illustration of how you cannot have one without the other!

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Attachments

  1. Valeant - Valuation in November 2016

18 comments:

HARIKRISHNAN.T said...

hi sir,

I don't know the how much will be the relevance of this question related to this post. I wanted to know because of my curiosity. While investing in stocks you look only DCF valuation or go with the combination of DCF and relative multiples?

Thanks in Advance
Harikrishnan

Anonymous said...

Part of the answer to whether to sell or hold on not only has to do with the new gap in your view of intrinsic value vs mkt price, but what else can you do with the money if you sell and what are the prospects for recovery of the loss from making the new purchase? The goal is not to be right, but to make money on your overall portfolio so it seems to me that given the uncertainty with the company it may take much longer to recover than you think and the headline news/ and mood regarding the company means it unlikely to move up appreciably without really showing it can generate improved operating results and litigation risk is manageable or decreased. Dead money for now.

Baptiste Roussel said...
This comment has been removed by the author.
Baptiste Roussel said...

Dear Pr Damodaran,

There seems to be a discrepancy in the number of shares outstanding from different data sources:

Most recent 10Q: 347,669,858
Yahoo finance: 347.67
Google finance: 341.19

(You used: 347.54)

Here the difference between Google and the most recent 10Q is 1.7%.

Value per share (10Q data/Yahoo): 32.50
Value per share (Google data): 33.10
About a 2% difference

In such cases, where do you recommend to get the data from?

Best,

Baptiste Roussel said...

Valeant's own website reports:
Shares in Issue: 343,101,797

Sam said...

Dear Professor, I'm a subscriber to your blog (via my id deepvaluecapital [@] outlook) and eagerly look forward to reading your posts. Possible for you to modify the subject line of your posts when the emails come in? Currently, for every blogpost, the subject reads as "Musings on Markets". Having a different subject will make it a lot easier to look for specific posts in my mailbox.

Thanks,
Sam

sushant patodi said...

Every time an unforeseen event jolts the stock market, the weaker hands exit first.
In the recent turmoil in the domestic stock market due to the unexpected outcome of the US presidential election and Prime Minister Narendra Modi’s surprise demonetisation drive, shares of many retail-heavy stocks have seen sharp cuts. Equity tips


Irishmist said...

My view on Valeant is as follows....
it used to be worth about 10 to 15 a share before Pearson took it on a wild ride...
Most of his acquisitions did not add real value; ok - some price gouging...
Look at the day it bought B&L - the acquirer's market cap jumped almost $8Bn - makes little sense...
So my bottom for this stock has always been $10 - $15 a share..

Anonymous said...

Thank you for the article. I wonder about the assumption that margins will revert to the 2011-2015 average in the terminal year - for instance, I think an interesting question to think about is whether this company in the mature slow-growth phase can maintain the same margins as when it was in its faster growth phase.

Halli said...

Dear Damodaran, I love this post as all the stuff you do. Traditionally we make our valuations using change in working capital and capex rather than using the sales/capital ratio as you do, but we have been trying to "update" and use your method. Too often I find this method, even if it sounds simpler/more intuitive at the outset, to be less transparent in practice (perhaps I am just used to the old way of doing things...).

E.g. in your model for Valeant, you calculate their current sales/capital as 0.28, but in the valuation you right away use 1.00 for the ratio. Why do you do this? Also, in practice, how would this happen? I'm assuming it would involve reducing the capital needed, but to do that you need to e.g. write off still more intangibles/goodwill, but there is not much equity left to be reduced as a consequence (only 4 billion whereas total intangibles=38bn and of that goodwill is about 17bn). Or do you not need to worry about this at all, i.e. how you get from the current 0.28 to the estimated 1.00?
Best, Halli

Anonymous said...

Wait, so you take EBIT(1-t) and add back "reinvestment" and call it FCFF? This isn't correct, is it?

Aswath Damodaran said...

Halli,
You are right. One of the perils in using sales to capital is that there is not only less transparency but also the possibility that you are not investing enough to sustain your growth. One way I check for this is by keeping track of the imputed return on capital (which I compute by adding the reinvestment each year to the invested capital) and seeing what that number looks like over time. One reason that Valeant's historical sales to capital ratio is so low is because they are an acquisitive company and book capital is inflated because it includes the value of growth assets, paid for up front. You can try to net out goodwill but it is a mess. One final point, the value is almost unaffected by the sales to capital ratio assumption here because there is so little growth.

SH22 said...

Mr. Damodaran, thank you for the consistent intellectual humility and this assessment. I was anxious to see an updated view of VRX from you.

Quick question: would you agree that the stock is trading on both a) the fear of nasty findings in the misc. gov't investigations and b) the debt load?

If so, it would seem near term catalysts may be seen: a) gov't findings are possibly lighter than feared (what is with this comparison to Enron?) and b) an asset sale at a decent price (e.g. Salix).

Brody said...

Professor Damodaran,

I noticed that you increased your years 5-10 operating margin from 40.39% to 45.13% in your second analysis. I was wondering why. In your note in the model you say adjusted for R&D. So, you're thinking that they will begin to capitalize some R&D expenses (I see you have them reinvesting in year 3, which is when the margin begins to increase), and these expenses will bypass the income statement, therefore increasing the operating margin? Why do you think that will happen? Valeant's R&D capabilities have historically been weaker than their competitors given their reliance on acquisitions. Isn't it possible that they have to increase SG&A expenses to increase their R&D capabilities? This would offset any capitalization benefit they receive from the bit of R&D they can capitalize.

The margin seems to be a relatively sensitive input into your valuation. For example, if you were to keep the margin flat at 40.39% like you originally did the valuation drops from $32.50 to $23.19. This still leaves 55% upside to its $15.00 price, but that alone eliminates nearly 30% of VRX's value per share. Why is 45.13% your base case for years 5-10 margin? And what range did you use for the 5-10 year margin assumption (upside/downside)?

Thank you,
Brody

Unknown said...

How do you take risk of bankruptcy into account when decided whether to double down on a holding that has dropped in price? Do you set a cap on % of portfolio for each holding, and if so how is that determined?

EAC said...

Aswath,

I've been looking at Valeant for a long time now and I believe there is a fundamental issue with your analysis. Though it is probably an argument you've heard raised before I would recommend the last paragraph of this post as an important thought-experiment.

While I understand your concerns about Goodwill and Acquired Intangibles, I would argue that the Intangibles Valeant has purchased are not ephemeral things which can't be accurately quantified and don't economically depreciate - what they purchased were patent portfolios with defined lives (or generic products with competitive pressures). As such, the amortization of these intangibles is economic and the cash-flow associated with that amortization is more accurately a return OF capital rather than a return ON capital (as your analyses seem to imply by using a pre-amortization EBIT for your ROIC calculation).

Effectively, VRX has raised a lot of debt to purchase wasting assets - just because those wasting assets are intangible does not mean they don't disappear (they're patents, they expire and then drug sales fall) and as such, the amortization of the intangibles is effectively the amortization of the debt used for the acquisition which must be paid back before the business disappears.

If I raised a bunch of debt to buy an airplane, the DD&A of that airplane would be deemed a real expense (and the DD&A cash-flow earmarked for debt pay-down) because in 20-25 years the airplane will be scrap. If I buy a patented drug I don't see why this should be any different. As such, adding back the amortization to calculate your ROIC would be like adding back depreciation on an airplane - when there's no airplane (drug portfolio) left there's no business left and debt-holders will expect the debt burden to be paid off before that happens. The other option is that maybe VRX's drug properties are perpetuities like Tylenol but from looking at their assets I would object strongly to any claim that anything other than a relatively small part of their business is a perpetuity (look at the gross margins, look at the revenue by product etc.).

A different way of discussing this is that, in your model from May, you appear to be assuming that ~$300m/yr of R&D can replace ~$2bln+/yr of drug portfolio amortization AND grow the bottom line by 3% annually; note that the ~$2bln/yr of amortization is effectively the capitalized value of R&D conducted by other pharmacies who undertook successful R&D - I have never heard a compelling argument for why VRX won't have to spend money replacing the acquired R&D. Your more recent model (which is considerably more complex) appears to be making a similar assumption.

Here is an interesting exercise that may elucidate the point. Broadly, given VRX's current product portfolio what would you expect to happen if Valeant spent $0 on R&D and paid out all of its EBIT (as you calculate the #) to shareholders every year for the next 10 years (let's assume for the moment that debt-holders would allow this)? What would the balance sheet look like? How would you expect Valeant's current product sales and EBIT to compare to sales/EBIT in Year 10? Year 20? What does your current model assume EBIT will look like in Year 10/20? What does that say about the assumed incremental returns on that ~$300m/yr of R&D?

I would be interested to hear your thoughts on this matter and would be happy to discuss this further.

d.grioli said...

Dear Professor,

Thanks for your post.

In previous posts (e.g. AAPL) you've written about intrinsic value being a range and not a single number. You've also illustrated this by showing the distribution of values that you've computed using Crystal Ball.

Have you done this for VRX? If so, I would be interest to see what the range of outcomes for VRX are.

Thanks

Daniel

Rashaad Tayob said...

How can you forecast revenue on a company which sells $10 tubes of cream for $500. Thats just too much on the faith aspect of valuation.