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)

 

Narrative Resets: Revisiting a Tech Trio (Apple, Facebook and Twitter)

In a post in August 2014, I examined the importance of narratives in valuation and how shifts or changes in those narratives can affect value, using Apple, Twitter and Facebook to illustrate my point. Since all of these companies have reported earnings in the last few weeks, I revisited my valuations of these companies, with the specific intent of seeing whether there is a need to update the narratives (and values) for these companies and whether, as an investor, I need to act.

Apple

I have been valuing Apple every quarter on my blog for the last four years. While I admitted in my very first posted valuation of the company that I liked the company and its products too much to ever be unbiased in my valuations, I did reluctantly sell my Apple shares when they hit $600 in early April 2012, arguing that the traders were driving the stock in ways that I could not comprehend. That turned out to be a lucky break, because the momentum shifted (as it does in pricing games), causing the stock to go into a tailspin. In January 2013, I reentered the Apple investor sweepstakes, when the stock hit $440, using this post to explain my rationale and in April 2014, I looked at the sometimes divergent paths taken by price and value at the company.

My August 2014 narrative

My last blog post valuation of Apple was in August 2014, after the stock had a 7 for 1 stock split, and the value per share that I obtained was $96. Starting in 2011, my narrative for Apple has been that it is a mature company, with limited growth potential (revenue growth rates< 5%) and sustained profitability, albeit with downward pressure on margins, as its core businesses becomes more competitive, and only a small probability that the company would introduce another disruptive product to follow up its trifecta from the prior decade (the iPod, the iPhone and the iPad). I saw no reason to change this narrative significantly, and as the stock was hovering around $100 at the time of the analysis, I considered it fully priced.

What’s happened since

The biggest news announcements from Apple came in September 2014, where they announced two new products, the Apple iWatch and Apple Pay. While I don’t see much in Apple iWatch to change my narrative in significant ways, Apple Pay offers the potential to provide a breakthrough, because the financial services business is a huge one and ripe for disruption. It is that shift that led me to hold Apple through the rest of 2014 and into 2015. In addition, Apple’s introduction of the iPhone 6 has allowed it to protect its margins much better than I had anticipated that they would. In a valuation that I did as part of my valuation class in March 2015, I revalued Apple at close to $118/share, about 10% below the stock price of $128 at that point in time, leading to a decision to sell the stock and count my blessings.

The August 2015 narrative

The last earnings report from Apple, which came out in late July, contains few surprises or twists, with perhaps the only surprising feature being the unexpectedly large jump in the cash balance to over $200 billion. That fact, while Apple continues to buy back billions in stock and pay large dividends, is a testimonial to the cash machine that Apple has created with its iPhones and iPads. In fact, just incorporating the higher cash balance and the lower share count into the valuation yields a value per share of close to $130. While you can download the valuation by clicking here, I also ran a simulation, where I allowed my assumptions on revenue growth, margins and cost of capital to vary to generate these numbers:

At the time of this post, the mood around Apple has darkened and the stock has dropped to less than $110. The purported reason for the stock price drop is the slow down in Apple sales in China, but that sounds to me like an attempt to fit a “good” reason to an old-fashioned sell off. Even allowing for a Chinese economic slowdown, Apple is starting to look like a bargain to me again but given the ebbs and flows in momentum in this stock, I would not be surprised if this round of selling leads the stock even lower, before good sense prevails. I think I will wait a few weeks before putting my buy order in but it looks like I will once more be an Apple stockholder.

Facebook

When Facebook filed for its initial public offering in February 2012, I described it as the most pre-priced IPO in history, as it had been actively traded in private markets before that offering. In my initial narrative for Facebook, I foresaw a company that would tread in Google’s path in terms of generating advertising revenues, while posting substantial profit margins. That “Google wannabe” narrative yielded a value of $71 billion for the company and a value per share of $28. Needless to say, I was not tempted to buy the stock at the offering price of $38 per share, but a few months later, I was extraordinarily lucky to get the stock at $18, as investors dumped the stock after its first earnings report. Since my narrative changed relatively little in the year following, my value changed little, but the stock price recovered to $45, leading to a decision on my part to sell.. The subsequent rise of the stock to $95/share meant that I left significant profits on the table by selling too early, but better than bailing on an investment philosophy that has worked for me.

My August 2014 narrative

In my August 2014 post on Facebook, following another blockbuster earnings report, where they reported more success in their mobile advertising efforts, I admitted that my original narrative was too cramped and that Facebook was perhaps on its way to outstripping Google not only in advertising but also in generating other ways of making money of its monstrously large (and involved) user base. The expanded narrative yielded a value per share of close to $63, still lower than the price at the time ($72) and I concluded that much as I liked the company, it looked over priced to me. 

What’s happened since

In its earnings reports in October 2014, January 2015 and April 2015  in Facebook continued to impress markets with its capacity to scale up revenues, while maintaining huge operating margins. In addition, other evidence accumulated that Facebook was moving forward briskly in its business model. In May 2015, Buzzfeed and the New York Times announced that they would be posting articles directly on Facebook, cementing its status as a news source. Facebook has also turned Instagram into a powerful tool for mobile advertising, with revenues of $600 million in 2015 and expected to rise to almost $3 billion in the next few years.

The August 2015 narrative

The last earnings report on July 29, 2015, continued this trend but it also included a note of caution from Mark Zuckerberg that investors should take to heart. He was explicit in his view, just as he was in the quarters before, that growth was getting more expensive and that investors should expect larger capital investments (and acquisitions) in the future. Looking at my August 2014 narrative, I see little need to make major changes to it, since I am already building in large reinvestment needs in the future. My updated valuation yields a value of $69/share and at its current price of $95, it is still too richly priced for my taste. Again, you can download the valuation by clicking here, but the simulation yields the following results:

At its current stock price of $94, I am not tempted yet, but I am all aware that this may be more a reflection of my narrative failure than a market mistake. In my August 2014 post, I described Facebook as a company where my valuations may chase the price for a long time and that is certainly turning out to be true.

Twitter

I valued Twitter for the first time in early October 2013, when the company filed its prospectus as a precursor to its initial public offering. My initial valuation of $18/share of the company is contained in this post from late October was based on the promise of advertising revenues that its large user base provided. While the initial offer price for the stock was set at $22, it was moved up to $26 and the stock itself opened for trading at $46 on the offering date. In the months after, the stock moved above $70 per share, before investors started noticing its flaws.

My August 2014 narrative

In my post on Twitter in August 2014, I stuck with my narrative of it becoming a successful but not-dominant online advertising companies, capable of commanding healthy margins, but added the concern that its management did not seem to have any control of this narrative or act in a way to make it happen. I contrasted how Twitter’s business model was a static one, relative to Facebook’s, and my estimate of value was $22.53, higher than the IPO number, but not by much. 

What’s happened since

It has been a tumultuous year at Twitter. In the aftermath of their stock price drop last year, they held an analyst meet in San Francisco in December 2014, where the CFO, Anthony Noto, tried to lay out the vision that the company had for its future. I must admit that I was underwhelmed by both how cramped that vision was and how little thought had been given to making it happen, and I posted my reaction in this post, where I likened it a bar mitzvah moment. If what has happened at the company in the months since are any indication, it looks like Twitter has a lot of growing up to do. After another bad earnings report, Twitter’s CEO, Dick Costolo, lost his job. That might have qualified as good news, but he was replaced by Jack Dorsey, who heads another company (Square). Twitter needs more than a part-time CEO and one who will represent a clean break from the status quo.

The August 2015 narrative

The last earnings report confirmed the chaos at Twitter. While the news in the report was not bad, investors latched on to the slowing growth in users as an excuse for selling off the stock. While I was disappointed in Twitter’s inability to extend its user presence especially overseas, Twitter’s bigger problem is not being able to convert its existing user base into revenues. There must be a way to monetize a social media presence that causes governments to quake, politicians to fall and breaks news ahead of established news services. My narrative for Twitter therefore is very similar to what it was in 2014. I believe that it will eventually get a management team that finds a way to convert potential to profits, stops catering to equity research analysts and expands its international presence. My valuation reflects this narrative and yields a value per share close to $26/share, and you can download it by clicking here. The simulation delivers the following numbers:

Note that the distribution of values for Twitter is much less symmetric that the distributions for Facebook and Apple, and is skewed towards larger values. IThis is not uncommon for small, high growth companies and is part of the "option" story, where you buy these companies to take advantage of the potential for breakout values. While the stock is, at best, fairly valued (at least based on my value), the optionality tilts the scale for me, and my (limit) buy orders were executed on Friday at $27/share. I am now a Twitter shareholder, and needless to say, I will keep you posted on how this investment evolves.

The End Game

Apple, Facebook and Twitter are three companies that I will continue to value at regular intervals and I will use them to remind myself of three fundamental propositions about value-based investing.

1. Never say never: I do not want to tar all value investing with the same brush, but a substantial proportion of "value" investors draw lines in the sand. You should never invest in stocks that operate in technology businesses, they tell you, and definitely not in social media companies. Not only do these rules make no sense, but they take larger and larger proportions of companies out of your investing universe. Much as I have taken issue with Twitter's management in the past, at its current price, it looks like a good value to me. Put more generally, at the right price, I would buy almost any company, even a risky one with bad corporate governance, and at the wrong price, I would not buy even the very best company.
2. Don't just buy and hold: The other piece of advice you get from value investors is buy great companies and hold them forever. This advice does not hold up either, since the essence of investing for value is that you buy an asset for a price that is less than its value. A consistent version of value investing would push for you to buy a a stock when the price is below value (with perhaps a margin of safety built in) but you should sell the stock when the price exceeds value (perhaps, using the same margin of safety in the other direction), even if you have held it for only a short period. If Apple continues its drop below $100, I will be buying Apple for the third time in four years and if Facebook sees a dramatic drop off in price to $60 per share or lower, I will buy it for the second time.  
3. PE Ratios are blunt instruments: Generations of investors have been brought up on the notion that you should screen stocks, using multiples of earnings (PE or EV/EBITDA) or book (price to book), and pick companies that trade at low multiples. Even if Twitter dropped to $20/share, it will not trade at a low PE, even if with forward earnings, but I think it will be a good value.

 Attachments

1. Valuation of Apple (July 2015) and Simulation Results
2. Valuation of Facebook (July 2015) and Simulation Results
3. Valuation of Twitter  (July 2015) and Simulation Results