A Valeant Update: Damaged Goods or Deeply Discounted Drug Company?

Rats get a bad rap for fleeing sinking ships. After all, given that survival is the strongest evolutionary impulse and that rats are not high up in the food chain, why would they not? That idiom, unfortunately, is what came to mind as I took another look at Valeant, the vessel in my investment portfolio that most closely resembles a sinking ship. This is a stock that I had little interest in, during its glory days as the ultimate value investing play, but that I took first a look at, after its precipitous fall from grace in November 2015. While I stayed away from it then, I bought it in May 2016 after it had dropped another 60% and I found it cheap enough to add to my portfolio. I then compounded my losses when I doubled my holding in October 2016, arguing that while it was, at best, an indifferently managed company in a poor business, it was under priced at $14 . With the stock trading at less than $12 (and down to $10.50, as I write this post) and its biggest investor/promoter abandoning it, there is no way that I can avert my eyes any longer from this train wreck. So, here I go!

Valeant: A Short (and Personal) History

I won't bore you by repeating (for a third time) the story of Valeant's fall from investment grace, which happened with stunning speed in 2015, as it went from value investing favorite to untouchable, in the matter of months. My first post, from November 2015, examined the company in the aftermath of the fall, as it was touted as a contrarian bet, trading at close to $90, down more than 50% in a few months. My belief then was that the company's business model, built on acquisitions, debt and drug repricing was broken and that the company, if it became a more conventional drug business company, with low growth driven by R&D, was worth $73 per share. I revisited Valeant in April 2016, after the company had gone through a series of additional setbacks, with many of its wounds self inflicted and reflecting either accounting or management misplays. At the time, with the updated information I had and staying with my story of Valeant transitioning to a boring drug company, with less attractive margins, I estimated a value per share of $44, above the stock price of $33 at the time. I bought my first batch of shares. In the months that followed, Valeant's woes continued, both in terms of operations and stock price. After it announced a revenue drop and a decline in income in an earnings report in November 2016, the stock hit $14 and I had no choice but to revisit it, with a fresh valuation. Adjusting the valuation for the new numbers (and a more pessimistic take on how long it would take for the company to make its way back to being a conventional, R&D-driven pharmaceutical company, I valued the shares at $32.50. That may have been hopeful thinking but I added to my holdings at around $14/share.

Valeant: Updating the Numbers

Since that valuation, not much has gone well for the company and its most recent earnings report suggests that its transition back to health is still hitting roadblocks. While talk of imminent default seems to have subsided, there seems to be overwhelming pessimism on the company's operating  prospects, at least in the near term. In its most recent earnings report, Valeant reported further deterioration in key numbers:

	2016 10K	2015 10K	% Change
Revenues	$9,674.00	$10,442.00	-7.35%
Operating income or EBIT	$3,105.46	$4,550.38	-31.75%
Interest expense	$1,836.00	$1,563.00	17.47%
Book value of equity	$3,258.00	$6,029.00	-45.96%
Book value of debt	$29,852.00	$31,104.00	-4.03%

Much as I would like to believe that this decline is short term and that the stock will come back, there is now a real chance that my story for Valeant, not an optimistic and uplifting story to begin with, is now broken. The company's growth strategy of acquiring other companies, using huge amounts of debt, raising prices on "under priced" drugs and paying as little in taxes as possible were perhaps legally defensible but they were ethically questionable and may have damaged its reputation and credibility so thoroughly that it is now unable to get back to normalcy. This can explain why the company has had so much trouble not only in getting its operations back on track but also why it has been unable to pivot to being a more traditional drug company. If researchers are leery about working in your R&D department, if every price increase you try to make faces scrutiny and push back and your credibility with markets is rock bottom, making the transition will be tough to do. It can also indirectly explain why Valeant may be having trouble selling some of its most lucrative assets, as potential buyers seem wary of the corporate taint and perhaps have lingering doubts about whether they can trust Valeant's numbers.

In fact, the one silver lining that may emerge from this experience is that I now have the perfect example to illustrate why being a business entity that violates the norms of good corporate behavior (even if their actions legal) can destroy value. At least in sectors like health care, where the government is a leading customer and predatory pricing can lead to more than just public shaming, the Valeant story should be a cautionary note for others in the sector who may be embarking on similar paths.

The Ackman Effect

You may find it strange that I would spend this much time talking about Valeant without mentioning what may seem to be the big story about the stock, which is that Bill Ackman, long the company's biggest investor and cheerleader and for much of the last two years, a powerful board member, has admitted defeat, selling the shares that Pershing Square (his investment vehicle) has held in Valeant for about $11 per share, representing a staggering loss of almost 90% on his investment. The reasons for my lack of response are similar to the ones that I voiced in this post, when I remained an Apple stockholders as Carl Icahn sold Apple and Warren Buffett bought the stock in April 2016. As an investor, I have to make my own judgments on whether a stock fits in my portfolio and following others (no matter how much regard I have for them) is me-too-ism, destined for failure.  

Don't get me wrong! I think Bill Ackman, notwithstanding his Valeant setbacks, is an accomplished investor whose wins outnumber his losses and when he takes a position (long or short) in a stock, I will check it out. That said, I did not buy Valeant because Ackman owned the stock and I am not selling, just because he sold. In fact, and this may seem like a stretch, it is possible that Ackman's presence in the company and the potential veto power that he might have been exercising over big decisions may have become more of an impediment than a help as the company tries to untangle itself from its past. I am not sure how well-sourced these stories are, but there are some that suggest that it was Ackman who was the obstacle to a Salix sale last year.

Valeant: Three Outcomes

As I see it, there are three paths that Valeant can take, going forward.

1. Going Concern: To value Valeant as a going concern, I revisited my valuation from November 2016 and made its pathway to stable drug company more rocky by assuming that revenues would continue to drop 2% a year and margins will stay depressed at 2016 levels for the next 5 years and that revenue growth will stay anemic (3% a year) after that, with a moderate improvement in margins. With those changes put in and leaving the likelihood that the company will not make it at 10% (since the company has made some headway in reducing debt), the value per share that I get is $13.68. 

Download spreadsheet

To illustrate the uncertainty associated with this value estimate, I ran a simulation with my estimated distributions for revenue growth, margins and cost of capital and arrived at the following distribution of values.

The simulation confirms the base case intrinsic valuation, insofar as the median value of $13.31 is close to the price at the time of the valuation ($12) but it provides more information that may or may not tilt the investment decision. There is a clear chance that the equity could go to zero (about 12%), if the value dips below the outstanding debt ($29 billion). At the same time, there is significant upside, if the company can find a way to alter its trajectory and become a boring, low growth drug company.

2. Acquisition Target: It is a sign of desperation when as an investor, your best hope is that someone else will acquire your company and pay a premium for it. I am afraid that the Valeant taint so strong and its structure so opaque and complex that very few acquirers will want to buy the entire company. I see little chance of this bailing me out.

3. Sum of its parts, liquidated: It is true that Valeant has some valuable pieces in it, with Bausch & Lomb and Salix being the biggest prices. While neither business has attracted as much attention as Valeant had hoped, there are two reasons why. The first is that Ackman, with significant losses on the stock and a seat on the board, may have exercised some veto power over any potential sales. The second is that potential buyers may be scared away by Valeant's history. One solution, now that Ackman is no longer at the company, is for Valeant to open its books to potential acquirers and sell its assets individually to the best possible buyers. Note that this liquidation value will have to exceed $29 billion, the outstanding debt, for equity investors to generate any remaining cash.

There is one other macro concern that may make Valeant's future more thorny. As a company that pays a low effective tax rate and borrows lots of money, the proposed changes to the tax law (where the marginal tax rate is likely to be reduced and the tax savings from interest expenses curbed), Valeant will probably have to pay a much higher effective tax rate going forward, one reason why I have shifted to a 30% tax rate for the future.

The Bottom Line

Let's start with the easy judgment. This was not an investment that I should have made and much as I would like to blame macro forces, the company's management and Bill Ackman for my losses, this was my mistake. I was right in my initial post in concluding that the company's old business model (of acquiring growth with borrowed money and repricing drugs) was broken but I clearly underestimated how much damage that model has done to the company's reputation and how much work it will take for it to become a boring, drug company. In fact, it is possible that the damage is so severe, the company will not be able to make the adjustments necessary to survive as a going concern. 

So, now what? I cannot reverse the consequences of my original sin (of buying Valeant at $32) in April 2017 and the secondary sin (of doubling down, when Valeant was trading at $14) by selling now. The question then becomes a simple one. Would I buy Valeant at today's price? If the answer is yes, I should hold and if the answer is no, I should fold. My intrinsic value per share has dropped to just above where the stock is trading at now, and at this stage, my judgment is that, valued as a going concern, it would be trading slightly under value. In a strange way, Bill Ackman's exit is what tipped the scales for me, since it will give Valeant's management, if they are so inclined, the capacity to make the decisions that they may have been constrained from making before. In particular, if they recognize that this may be a clear case where the company is worth more as the sum of its liquidated parts than as a going concern, there is still a chance that I could reduce my losses on this investment. Note, though, that based on my numbers, I don't expect to make my original investment (which averages out to $21/share) back. I am not happy about that but sunk costs are sunk!

As I continue to hold Valeant, I am also aware that I might be committing one of investing's biggest sins, which is an aversion to admitting mistakes by selling losers. My discounted cash flow valuations may be an after-the-fact rationalizing of something that I don't want to do, i.e., sell a big loser. To counter this, I briefly considering selling the shares and rebuying them back immediately; that makes me admit my mistake and take my losses while restarting the investment process with a new buy, but the "wash sales" rule is an impediment to this cleansing exercise. The bottom line is that if I am holding on to Valeant, not for intrinsic value reasons (as I am trying to convince myself) but because I have an investing blind spot, I will be last one to know!

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Previous Posts on Valeant

1. Checkmate or Stalemate: Valeant's Fall from Investing Grace (November 2015)
2. Valeant: Information Vacuums, Management Credibility and Investment Value (April 2016)
3. Faith, Feedback and Fear: The Valeant Test (November 2016)

Spreadsheets

1. Valeant Valuation: March 2017

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, Q3	2015, Q3	Change	2016, Q1-3	2015, Q1-3	Change
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:

Download spreadsheet

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

Checkmate or Stalemate? Valeant's Fall from Investing Grace

In my last post, I looked at how the pharmaceutical and biotechnology businesses have diverged, especially in the last decade, and the implications for earnings, R&D and market pricing of these companies. The pharmaceutical business, in particular, faces a new landscape with many companies still stuck with a business model that does not work in delivering value, as growth eases and margins come under pressure. It is no surprise therefore that investors are looking for a drug company with a new business model, and that may explain the meteoric rise of Valeant over the five years, making its recent collapse all the more shocking.

Valeant: The Rise

The best way to illustrate Valeant's rise in the drug business is trace its history in numbers. The graph below looks at the time line of revenues, operating income and net income from 1993 to the the last twelve months ending in September 2015:

As you can see, the inflection point is in 2010, when Valeant went from a company with small, slow-growing revenues into hyper speed, increasing revenues almost ten fold between 2010 and 2015. That increase in revenues was accompanied by increases in operating income and net income, albeit smaller in proportional terms. The story of how Valeant was able to accelerate its growth has been widely told, but the numbers again tell it better.

Year	R&D	Acquisitions	R&D/Sales	Acquisitions/Sales
2005	$69.42	$-	7.40%	0.00%
2006	$77.80	$-	7.29%	0.00%
2007	$100.61	$-	11.94%	0.00%
2008	$69.81	$101.90	9.22%	13.46%
2009	$47.58	$-	5.80%	0.00%
2010	$67.91	$(308.98)	5.75%	-26.16%
2011	$65.69	$2,464.10	2.71%	101.51%
2012	$79.10	$3,485.30	2.27%	100.14%
2013	$156.80	$5,253.50	2.72%	91.12%
2014	$246.00	$1,102.60	2.98%	13.35%
LTM	$297.60	$14,123.20	2.98%	141.46%

The growth has been driven almost entirely by acquisitions, totaling $26.4 billion since 2010. Looking closer at the 23 acquisitions that Valeant has made since 2013, the company has bought more private businesses (18 out of the 23) than public, though a very large proportion of the total cost can be accounted for with two acquisitions, one of a public company (Salix for $12.5 billion) and one of a private business (Bausch and Lomb for $8.7 billion. Valeant seems to have also paid for almost all of these acquisitions with cash, which raises the interesting follow up question of where they came up with the cash. Again, the answer is in the numbers, with the chart below providing a breakdown of funding sources during the period from 2011-2015, the peak period for Valeant's acquisitions:

Source: Valeant Statement of Cash Flows

At least during this period, the market liked the Valeant business model of growth through acquisitions, and delivered its verdict by pushing up Valeant's market capitalization and pricing multiples.

Valeant: The Fall

It is perhaps because Valeant rose so quickly from its mid-cap status to become a star that its precipitous fall has been so shocking. The decline started with a report, on October 19, on a court filing in California and picked up steam when it was highlighted on October 21 by Citron, an outfit that has long been critical of Valeant's accounting and operating practices. That report claimed that Valeant had hidden a relationship with shadowy pharmacy entities and that it had used that relationship to cook its books. While some were quick to dismiss the report as motivated by Citron's short position in Valeant, the report triggered scrutiny and Valeant's initial explanations satisfied no one and the market reacted accordingly:

Recognizing that it faced a major market calamity, Valeant called a press conference on October 26, where they tried to clear the air, succeeding only in making it murkier by the time they were done. In the days since, the piling on has begun with even long time investors in the company finding aspects of the company that they had never liked. The stock price dropped below $80 per share on November 5, down more than 60% from its peak in August. In fact, things have gotten so bad that the CEO of Valeant, Michael Pearson, was forced to sell $100 million of his shares in the company to cover a margin call.

Valeant's Business Model

The formula that Valeant used to grow exponentially, i.e., acquiring smaller companies and bringing them under one corporate umbrella, is not new, and given the mixed track record of companies that have tried it, it is not generally greeted with the rapturous response that Valeant received. To add to the puzzle, many of the investors who were drawn to the stock were from the old-time value investing crowd, with the Sequoia Fund and Bill Ackman among its biggest cheerleaders. So, what is it that attracted these presumably hard-headed investors to the Valeant business model?

1. Buy low, sell high:  I believe that value investors were attracted to Valeant because it seemed to adapt an old-time value investing maxim of buying "cheap and selling expensive" to the drug market. At the risk of over simplifying Valeant's strategy, a central focus of its acquisition strategy was buying companies that owned the rights to "under priced" drugs and repricing to what the market would bear. 
2. Use debt capacity: One of the enduring mysteries of the drug business, where mature companies have large and stable cash flows from developed drugs, is why these companies do not borrow more to take advantage of the tax code's tilt towards debt. As you can see from the funding pie chart above, Valeant seemed to have no qualms about using its borrowing capacity to fund its acquisitions. 
3. R&D is not sacred: In my last post on the drug business, I noted the reduced payoff (in growth) to R&D expenditures at pharmaceutical companies and the unwillingness on the part of these companies to draw back their R&D expenditures. Again, Valeant seemed to be one of the few companies in the business that viewed R&D like any other capital investment and scaled it back, as the payoff decreased.
4. Quick conversion into earnings: Many acquisitive companies fail at converting great sounding stories into earnings, but Valeant seemed to be exception. Its acquisitions seemed to translate quickly into revenues and operating income, vindicating their strategy, though you had to take the company's word that its acquisition-related expenses were transitional and one-time charges. As an added bonus, Valeant used its acquisition-related expenses to keep its tax bill low, getting tax credits from 2011 to 2013 and keeping its effective tax rate below 10% in the most recent twelve months.

The collapse of Valeant's stock price has created more than the usual second guessing and rewriting of history, with some glee mixed in, given the pedigree of the investors who have lost money on the company. While my deep seated skepticism about acquisitions has meant that I was never tempted to buy Valeant, even in the good times, I understand its appeal to investors. In a business (pharmaceuticals), where inertia and denial seem to drive management decisions at most companies, Valeant looked like an outlier with a business template that worked.

Game Changer?

I have argued in prior posts that big shifts in intrinsic value don't come from earnings surprises or market panics, but from big changes in narrative. The question that investors (both current and potential have to ask about Valeant is whether the company narrative has been altered enough by the news stories that we are reading for it to lose more than half of it's value. If you accept my description of the Valeant business model (acquisitions focused on repricing drugs, funded with debt and quickly converted into earnings), there is reason to believe that a critical portion of the Valeant's business model is broken and cannot be fixed.

1. Health care is different: Unlike perfume, soda or an automobile, where charging what the customer will pay is exactly what businesses should aspire to do, it seems inhumane and perhaps even immoral to push prices up 60% or 70% for medicine that patients need.  Even if you don't have moral objections to the practice, you may still have issues with it as a citizen and taxpayer, since these costs are spread across all of us through the health insurance system. It is surprised that Valeant has not been subject to more scrutiny for this practice, but  it was becoming clear even before the recent blow up that the company was drawing attention, as evidenced by this article in the New York Times on October 14 (a few days before the short seller stories appeared in the press). Now that Valeant is in the public eye, there is no way that, even if this scandal passes, they can return to anonymity. Every drug price increase for a Valeant drug will be held up to scrutiny and subject to second guessing and any target company that want to fight off a Valeant acquisition bid will now be pre-armed. 
2. Distribution network: The distribution and sale of drugs is different from most other conventional businesses, with doctors, pharmacies and insurance companies all operating in constrained environments,  with the constraints becoming more binding with changes in health care laws. Thus, doctors are asked to consider the relative prices of drugs when writing prescriptions and pharmacies are under pressure from insurance companies to consider cost when filling these prescriptions. As I read the news stories about the pharmacies controlled by Valeant, my suspicion is that the company used this  convoluted network (see the picture below from the Globe and Mail about Valeant's holdings)  to extract higher prices through to insurance companies and patients, rather than as device to cook its accounting books. Now that the relationship has come to light, it is probable and perhaps even likely that if this type of relationship is legal now, it will get more regulated or even banned in the future.
3. Accounting games: Part of Valeant’s rise can be attributed to the laziness of analysts, who apply multiples (that they pull from a cursory assessment of the comparable) on pro forma earnings, and some of it to the debris of acquisition accounting (goodwill, impairment of goodwill and acquisition-related restructuring charges).  I have written before about the damage that goodwill does to both accounting statements and to good sense, but the degree to which acquisition accounting has muddied up the numbers at Valeant can be captured by looking at how they have taken over Valeant's financials in the last 5 years:

   

   Source: Valiant Financial Statements

4. Complexity: Valeant is a complex company, and its complexity is brought home by both the bulk of its annual filing (its last 10K from 2014 runs 537 pages) and its detail. That complexity comes partly from its strategy of growing through acquisitions and partly from the accounting for acquisitions, but some of it is clearly by design (with the pharmacy network and chess names for holdings).  Complexity is a double-edged sword, though, since in good times, investors assume the best about the things that they do not know or understand and in bad times, the fog created by complexity creates a backlash. 

As with every scandal, I am sure that there will be new revelations and news stories in the week ahead, some pointing to accounting problems, some to business model failures and some to legal jeopardy. Even if Valeant emerges unscathed legally from this mess, I just don’t see how they can revert to their old business model, and it is not clear to me that without it, they are anything more than a middling pharmaceutical company.

The Bottom Line

Does the imminent collapse of Valeant's core business model imply that I agree with the short sellers who have used the Enron analogy to argue that this company is a shell worth nothing? No, and here is why. Unlike Enron, a company that used special purpose entities and complex holdings to hide it debt and had no assets with tangible value at the time of its troubles, Valeant pharmacy holdings seem designed more for pricing power than accounting sleight of hand and it owns assets that have real value. Thus, even if Valeant's capacity to grow productively is removed tomorrow, it will still have value as a going concern or as a collection of assets.

Going concern value

If Valeant is able to make it through its troubles intact, one option that is available to it is to become a more conventional drug company, resting on R&D for (low) growth and making money of its established products. To value Valeant in this scenario, here are the assumptions that I made:

• Base year earnings: One of the positive effects of suspending an acquisition-driven strategy is that the expenses associated with acquisitions should also dissipate. Consequently, I added back acquisition-related expenses (impairment of goodwill, acquisition charges) to operating income to get to an adjusted operating income for the last twelve months. (Update: As some of you have pointed out, the most twelve months of financials include only six months that include Salix and thus understate revenues and operating income. To remedy this, I need to bring in Salix's revenues and operating income from the last quarter of 2014 and the first quarter of 2015 into my trailing numbers. Unfortunately, Salix did not file a first quarter earnings report for this year, but here is an approximation. In 2014, Salix generated $1.134 billion in revenues but reported an operating loss. If you assume that revenues come in evenly over the year and you allow for the operating margin of 25.51% that Salix earned in 2012 & 2013, you get revenues of about $567 million and operating income of $145 million for the missing quarters. Adding these to the trailing 12 month numbers increases the value per share to $77. A more optimistic take, where Valeant is able to earn its higher operating margin increases the value per share to $81. The bottom line is that bringing in Salix's bump to revenues and operating income, which is likely to create growth in the next twelve months, pushes up value per share but not by enough to change my basic conclusion, which is that the stock is, at best, fairly valued.)
• Pricing backlash: I assumed that the controversy over Valeant's drug pricing strategy will result in roll backs of price increases on some of its drugs, resulting in a permanent drop of 10% in earnings. (Update: Though this number seems to come out of left field (and it is subjective), it comes from lowering Valeant's pre-tax operating margin (prior to adjustments) of 28.3% towards that of other drug companies which is 25.5%; the drop of 2.8% is roughly the 10% drop. I am also assuming that once the losses from prior acquisitions roll off, the tax rate will move up to 20%, lower than the tax rate paid by US pharmaceutical companies, reflecting the company's Canadian base.)
• Low growth: If Valeant follows the standard pharmaceutical company practice of investing in R&D and hoping for payoffs, its expected growth rate will drop to anemic levels (as suggested by my last post on drug companies). I will assume a 3% growth rate in earnings for the next 10 years, well below the 20% posted by Valeant over the last 5 years, but much of that growth was acquired. (Update: I know that management is forecasting 10% from organic growth. That may very well be true for next year, as the Salix bump kicks in, but it is tough to sustain thereafter, with substantially increasing R&D.)
• R&D spending: I will assume that Valeant will have to invest in R&D to keep this growth going, and in my valuation, that investment will reflect the return on capital of 15.25% that I have estimated for the company (with the adjusted earnings).
• Cost of capital: Factoring in both the good side of Valeant's high debt ratio (the tax effected cost of debt) and the bad side (higher cost of debt and equity) and the revenue exposure for Valeant (75% from developed markets, 25% from emerging markets), I estimate a cost of capital of 7.52%.

The value that I estimate for Valeant's equity, on a per share basis, is $72.10, which is about 14% lower than the price of $83.64 at the close of trading on November 10. Your views on Valeant may be very different from mine, and you are welcome to use my spreadsheet to reflect those views. The table below summarizes the effect on value per share of varying some of the assumptions:

Spreadsheet with valuation

Given my perspective on the company, and it is undoubtedly flawed, I don't see Valeant as a significantly under valued stock, in spite of the price drop over the last few weeks. I also don't see it as bubble waiting to burst, a stock heading towards being worth nothing. For the moment, I think will sit on the sidelines and watch.

Sum of the parts

If this scandal has legs and not only lingers, but creates legal problems that taint Valeant as a corporation, there is a second option. Just as Valeant’s rise in value was built on additions, you could create a reverse strategy where value is generated by subtraction. Thus, Valeant could sell itself piece by piece (drugs and divisions) to the highest bidders, since each piece will be worth more to an untainted buyer than it would be worth to Valeant. If this is the optimal path, it will be interesting to see if this team that has built the company up over the last five years is willing to set aside hubris and break it down over the next few years.

The Bottom Line
The Valeant story reinforces many of my existing biases against companies that grow primarily through acquisitions. I am willing to concede that this strategy can pay off, if companies maintain discipline, but my experience with these companies is that they inevitably hit a wall, either because they become too large to stay disciplined or because the accounting creates too many opportunities to obfuscate and hide problems. While Valeant's attempt at creating a new model for a drug business may have failed, that does not make the existing drug company model a success either. The search has to go on!

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Blog posts in this series

1. Divergence in the Drug Business: Pharmaceuticals and Biotechnology
2. Checkmate or Stalemate? Valeant's Fall from Grace
3. Runaway Stories and Fairy Tale Endings: The Theranos Lesson
4. Value and Taxes: Breaking down the Pfizer- Allergan Deal

Data Attachments

1. Valeant 10K and 10Q
2. Valeant historical financials

Spreadsheets

1. Valeant Valuation in November 2015