A Viral Market Update X: A Corporate Life Cycle Perspective

Fear and greed are dueling forces in financial markers at all times, but especially so in periods of uncertainty, when they pull in opposite directions, causing wild market swings and momentum shifts. I think that no matter what your market views are right now, you would agree that we are in a period of intense uncertainty, with divergent views on how this pandemic will play out, not just in the coming months, but in the coming years. It is this divergence that have been at the heart of both the steep fall in equity markets in February and March, and the equally precipitous rise in April and May. As US equity markets climb back towards pre-crisis levels, the focus on market levels may be missing the underlying shift in value that has occurred across companies. In this post, I will focus on this shift, using the framework of a corporate life cycle, and record a redistribution of value from older, low growth, more capital intensive companies to younger, high growth companies. It is possible that this shift is the result of irrational exuberance on the part of young, inexperienced investors, but I think that a more plausible explanation is that it reflects not only the unique nature of this crisis, but also a changing business landscape.

Updating the Market

As with my previous updates, I will start with a chronicling of how markets have behaved in the two weeks since my last update, and overall, during the crisis. Let's start with equity indices, where we saw one week of relative stability (5/29-6/5) and a week of drama (6/5-6/12), after surges in April and May:

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For those who thought that the worst of the crisis was behind them, June 11 delivered the message that this crisis is not quite done, as the S&P 500 dropped 7%, and markets around the world followed. I have computed the returns since February 14, broken down into two time periods, with the first stretching from February 14 to March 20, and the second from March 20 to June 12. Every equity index that I list in this table dropped in the first phase, with some indices losing more than 30%, as fear stalked markets around the world. In the second phase, every index posted positive returns, with some climbing back almost to pre-crisis levels. I will return to look at equities in more detail in the next section, but as stocks were going through contortions, US treasury yields were also on the move:

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US treasury rates dropped in the first weeks of the crisis, and with 3-month yields dropping close to zero and 10-year rates declining below 1%. While it is convenient to attribute everything that happens to interest rates to the Fed, note that much of the drop in rates occurred before the Fed's two big moves, the first one on March 15, where the Fed Funds rate was cut by 0.5% (almost to zero) and a $700 billion quantitative easing plan was announced, and the second one on March 23, when the Fed lifted the cap on its easing plan and extended its role as a backstop in the corporate bond and lending markets. While treasury rates were not affected much by the Fed's actions, its entry into the corporate bond market played a key role in turning the tide, where default spreads across ratings classes had been on the rise since February 14:

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Default spreads followed the path of equities, widening significantly between February 14 and March 20, and falling back by June 12, albeit to levels higher then on February 14. The fear about how the pandemic would slow economic growth also affected commodity prices, and I chart the path of copper and oil, two commodities sensitive to global economic growth below:

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As with corporate bonds and equities, it is a tale of two periods, with commodity prices dropping between February 14 and March 20, before clawing their way back in the subsequent period. With copper, the market has retraced its entire decline, and it is now back to where it was trading at, on February 14. With oil, it is a different story, with a decline of more than 50% between February 14 and March 20 in both Brent and West Texas crude. and oil prices, notwithstanding a strong recovery between March 20 and June 12, are about 30% lower than they were on February 14. Finally, I look at gold and bitcoin, gold, because it has historically been a crisis asset and bitcoin, because it has been marketed by some as an alternative asset:

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Gold has held its value and is up 9.28% during the crisis, though it saw less upside during the first few weeks of this crisis than in prior ones. Bitcoin has behaved more like equity, and very risky equity at that, during this crisis, dropping almost 40% between February 14 and March 20, before recovering to close down only 10.67% by June 12.

Equities: A Breakdown

In keeping with a practice I have adopted on my prior updates, I downloaded individual stock data on 37,050 publicly traded global companies, with market capitalizations exceeding $5 million, and computed changes in market cap, by region:

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Looking at overall returns from February 14 to June 12, the worst performing regions in the world are mostly in emerging markets (India, Latin America and Africa), with the UK as the worst performing developing market, down about 20%.  Breaking down the companies by sector, I look at returns across the period, broken down into two sub periods:

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The sectors with double digit negative returns over the entire period are energy, utilities, real estate, industrials and financials, with the first four being punished for their capital intensity and debt dependence, and financials reflecting the fear of debt defaults. Health care shows almost no change in value over the entire period, and tech is down only 3.2%. Breaking the sectors down into industries, and looking at returns over the crisis period, I list out the ten worst and best performing industries between February 14 and June 12, 2020:

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There are no surprises here, given the earlier sector assessment, with a strong representation of infrastructure and financial service companies among the worst performing sectors, and health care and technology on the best performing list. 

Crisis Effects across the Corporate Life Cycle

In each update on the crisis, I have tried to look at a different facet of market performance, hoping to get some understanding of  what the market is pricing in, and whether it makes sense. This week, I will use the concept of a corporate life cycle, a structure that I have found useful in thinking about both corporate financial questions and in valuation, and look at how this crisis has played out across the life cycle. 

The Corporate Life Cycle

I believe that companies, like humans, go through a life cycle from newborn (start up) to toddler to teenager, peaking as successful growth companies, before becoming middle aged (mature) and then declining. 

While there are companies that find pathways to reincarnation (IBM in 1992, Apple in 1999, Microsoft in 2013), they remain the exceptions to the rule that fighting corporate aging creates more costs than benefits. The life cycle is useful not just as a device for chronicling corporate age but also in identifying the challenges that companies face at each stage. It is also worth noting that the free cash flows, i.e., cash flows left over after taxes and reinvestment, vary as companies move through the life cycle:

In general, negative cash flows (cash burn) are a feature of young companies, cash build ups occur as companies grow and mature, and declining companies return cash as they shrink. Finally, to understand how companies change as they move through the life cycle, I will draw on another general construct, the financial balance sheet:

Note that young companies derive their value mostly or even entirely from growth assets, i.e., the value of investments that they are expected to make in the future, and that the portion that is attributable to assets in place increases as companies age, with mature and aging firms deriving most or all of their value from existing investments. Young companies, lacking the earnings and cash flows to service debt, are also more dependent on equity to fund their businesses than mature firms.

The Crisis Effect across the Life Cycle

A crisis tests all companies, but the dimensions on which they get tested will vary depending on where they fall in the life cycle. 

1. Start up and very young companies: For young companies, the challenge is survival, since they mostly have small or no revenues, and are money losers. They need capital to make it to the next and more lucrative phases in the life cycle, and in a crisis, access to capital (from venture capitalists or public equity) can shut down or become prohibitively expensive, as investors become more fearful. These companies will either have to shut down or sell themselves at bargain basement prices to larger, deeper-pocketed competitors.
2. Young growth companies: For young growth companies that have turned the corner on profitability, capital access still remains critical since it is needed for future growth. Without that capital, the values of these firms will shrink towards assets in place, and in a crisis, these firms have to hunker down and scale back their growth ambitions.
3. Mature firms: For mature firms, the bigger damage from a crisis is the punishment it metes to assets in place, as the economy slows or goes into recession, and consumers cut back on spending. The effect will be greater on companies that sell discretionary products than on companies that sell staples.
4. Declining firms: For declining firms, especially those with substantial debt, a crisis can tip them into distress and default, especially if access to risk capital declines, and risk premiums increase. 

In summary, the answer to the question of which companies (young or old) get affected more in a crisis will depend  on how the crisis affects the real economy and capital access. In most crises, it is access to capital that takes the early hit, with the pain from economic effects showing up more gradually. As a result, in the first parts of the crisis, it is the firms at either end of the life cycle (young companies and declining ones) that are most dependent on new capital to survive that are hurt the most, with the pain spreading more slowly to mature firms, and least to firms that sell consumer staples.   How has this crisis played out in terms of damage to companies across the life cycle? Let me start with a very simplistic measure of life cycle, company age, as measured from the year of founding:

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The table tells an interesting story. In the down phase (2/14-3/20), there was little distinction between younger and older firms, as firms in every age group lost about 30% of value. In the second phase from 3/20 to June 12, younger companies have seen a much more robust comeback than older firms, resulting in much lower negative returns over the entire period for younger firms (the bottom five deciles) than older ones (the top five deciles).  You could argue that company age is not a composite measure of where a company falls in the life cycle, since some companies move through the life cycle faster than others. To counter this critique, I break firms down by expected revenue growth, as estimated prior to the crisis, building on the assumption that expected revenue growth should be highest for young firms and lower for firms further along in the life cycle:

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Note that expected revenue growth estimates are available for just over a third of all the firms in my sample, and across those firms, the differences are stark. Firms in the lowest revenue growth decile are down substantially over the crisis period (2/14 - 6/12) whereas the firms with the highest expected revenue growth, coming into the crisis, have seen their values increase over the same period.  

In summary, this crisis seems to have had a much greater negative impact on older, more mature companies than on younger, high growth ones. perhaps because it started at a time, when capital markets were buoyant and investors were eagerly taking on risk, with risk premiums in both equity and bond markets at close to decade-level lows, with a global economic shut down, with a cessation of most business activity.  That shut down came with a time frame, though there was uncertainty not only about when economic activity would start up again, but how vigorously it would return. Young companies have also benefited from the fact, that after being on hold in the first few weeks of the crisis, risk capital came back in the middle of March, both in public and private markets. The big story, still unfolding, from this crisis is that access to risk capital has held up remarkably well, coming back into markets earlier and in larger magnitudes, than in prior crisis. The Fed has undoubtedly played a role in this comeback, especially with its  intervention in lending markets, but it has succeeded only because it tapped a willing investor base.That access to risk capital has also benefited distressed companies at the other end of the life cycle, explaining why you have seen surges in airline stock prices and in portions of the oil sector. To those who attribute the shift to amateur investors, subject to so much scorn from market watchers, there is collectively too little capital in the hands of these investors to have caused this much of a change in markets.

The divergence in the market treatment between young and older companies during this crisis also explains why value has underperformed growth, since value investing strategies skew towards more mature companies and growth investing is more focused on younger companies. It may also explain why so many market "pros" have been left in the dust by amateurs, since many of the former have been using scripts developed in prior crisis to decide when and where to invest, and this one has followed a different path. While value investors and pros may still be vindicated, the lesson that I would take from this crisis is that while it is true that those who do not remember history are destined to repeat it, it is also true that those who let history alone drive their investment decisions are in just as much danger. 

Conclusion

The trajectory of markets in this crisis has followed the path of the virus, with markets rising and falling on news about viral breakouts in different parts of the world, and vaccines/medication to mitigate its effects.  It should therefore come as no surprise that just as the virus has had its most deadly effects on the elderly and the infirm, the market is meting out its biggest punishment to mature and aging companies. As we pass the four-month mark since this crisis started roiling financial markets in the US and Europe, it is still an evolving story and there will be more twists and turns before it is done. 

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Data

1. Market data (June 12, 2020)
2. Regional breakdown - Market Changes and Pricing (June 12, 2020)
3. Country breakdown - Market Changes and Pricing (June 12, 2020)
4. Sector breakdown - Market Changes and Pricing (June 12, 2020)
5. Industry breakdown - Market Changes and Pricing (June 12, 2020)
6. Age breakdown - Market Changes and Pricing (June 12, 2020)
7. Growth breakdown - Market Changes and Pricing (June 12, 2020)

Viral Market Update Posts

1. A Viral Market Meltdown: Fear or Fundamentals?
2. A Viral Market Meltdown II: Pricing or Valuing? Investing or Trading?
3. A Viral Market Meltdown III: Clues in the Market Debris
4. A Viral Market Meltdown IV: Investing for a post-virus Economy
5. A Viral Market Meltdown V: Back to Basics
6. A Viral Market Meltdown VI: The Price of Risk
7. A Viral Market Update VII: Market Multiples
8. A Viral Market Update VIII: Value vs Growth, Active vs Passive, Small Cap vs Large!
9. A Viral Market Update IX: A Do-it-Yourself S&P 500 Valuation
10. A Viral Market Update X: A Corporate Life Cycle Perspective
11. A Viral Market Update XI: The Flexibility Premium
12. A Viral Market Update XII: The Resilience of Private Risk Capital
13. A Viral Market Update XIII: The Strong (FANGAM) get Stronger!

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:

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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!

YouTube Video


Attachments

1. Valeant - Valuation in November 2016