Special Situations: Public “Private Equity” Restructuring
August 13, 2016
- Recent PPS: $24.92
- Shares Out: 355 million
- Market Cap: $8,847
- Net Debt: $30,085
- Enterprise: $38,932
***Disclosure: This is a distressed, leveraged special situation trade with only the potential to turn into a medium- to long-term investment.***
I have been involved/followed the VRX saga for the last 2+ years, and have outlined my thoughts and analysis in detail via the following write-ups:
- November 2014 Investment Review
- July 2015 Investment Review
- November 2015 Situational Review
- November 2015 Quick Thoughts
- March 2016 Quick Thoughts
Since ‘puking’ up the stock in the first week of November (second November write-up) I have been firmly on the sidelines, resisting the urge to even trade the stock; but as of this week I am back in – for a trade (potentially an investment) – as I believe the latest earnings report turned VRX into a trade-able (potentially investable) special situation. In summary, my working thesis is that VRX is currently akin to a private equity restructuring (i.e. the ill-fated 2007/2008 Hilton PE deal consummated just prior to the GFC and restructured back to profitability by late 2013) that happens to be taking place in the public markets. [Pershing Square has long described its activism approach as a ‘public private equity’ methodology, and happens to be involved in this situation – but that is merely ironic, as a public restructuring was far from Pershing’s original thesis for VRX.]
Before walking thru the situational review, a quick note on price action…
The use of price action to inform fundamental analysis can be a slippery slope, as the market can quite literally do whatever it pleases in the short-term, and at extremes (think, March 2000 and March 2009 for the broad market) is by definition wrong. But within an investment ‘mosaic’ comprised of valuation, direction of fundamentals, sector/broad market backdrop, and an analysis of key holders, high-volume price action around key news items or a lack of news can be informative. My use of price action – outlined in the second November 2015 write-up attached above – allowed me to cut my losses in VRX in the first week of November 2015 when the stock declined on high volume on no news. In the November 2015 “Quick Thoughts” post cited above I said:
“Perhaps I am wrong – but after further discussion with fellow investors re biz model, the high volume annihilation to materially below $88.50 on virtually no news is greatly concerning to me.
“Perhaps the ‘short’ thesis will ultimately be proven correct; but at present, the two key drivers of VRX’s stock price liquidation are 1) an extremely concentrated ‘stuckholder’ base, and 2) uncertainty around future organic growth. It appears VRX’s business model was/is legitimate, but extremely aggressive; and when taken in the context of the extreme stock price liquidation, I believe the market is ‘telling’ us something. Maybe all is well and I just missed the home run buying opportunity I’ve been looking for down here – but I suspect the market is ‘telling’ us that the revenue base needs to be materially adjusted, and the valuation work needs to move to a more extreme downside scenario…“
Fast forward to August 9, 2016 when for the first time since VRX’s trading volume broke 100 million shares in a single day (third instance since March 15, 2016) VRX’s stock price rose on volume greater than 100 million shares. The stock was up ~25% and accelerated into the close, which IMO is indicative of more than simply short covering. A brief history of VRX’s stock price movement around 100 million share days:
- March 15, 2016: 138.95 million shares – stock falls from $69.04 to $33.51
- Stock goes on to bottom at $26.30 on 3/31
- June 7, 2016: 104.12 million shares – stock falls from $28.85 to $24.64
- Stock goes on to bottom at $18.73 on 6/27
- August 9, 2016: 105.85 million shares – stock rises from $22.45 to $28.16
Taken within the context of what I will outline below, I believe the high-volume response to what appears to be the first signs of stabilization in VRX’s earnings power is a bullish sign for trading purposes. Lots of hurdles left to clear to make VRX an investment, but 8/9 was a start.
Quick caveat: I was dead wrong in my interpretation of the late-October price action in the November 2015 “Situational Review” cited above, so I am taking my own interpretation of recent VRX events with a fat grain of salt and keeping the position on a tight leash.
- Large assets rarely go to $0
- Credit markets are relatively benign toward VRX
- Segment restructuring/transparency/asset sale guide precedes big restructuring push
- Pershing Square tripled down and is likely to fight
- Covenant relief catalyst toward big restructuring push
- Joe Papa sly like a fox?
(1) Large assets rarely go to $0. The ‘shorts’ have done unbelievable work on VRX, particularly with regard to the clearly unsustainable organic growth rates barfed up by Mike Pearson on a quarterly basis. The big reset in VRX’s sales base, IMO, proves this out. And while there is perhaps more erosion to go in the ‘core VRX’ sales base, I believe the bottom is close. Where I differ from the shorts is that VRX is a donut that generates little in the way of true cash flow. I fully agree that the non-GAAP EPS and EBITDA figures VRX guides to overstate true underlying earnings power – but A) not by much, and B) not to the extent that cash flow generation is nonexistent. For example…
In 1H16 VRX’s ‘adjusted’ EBITDA was $2,095 million, or 43.7% of sales. But after adjusting operating cash flow for working capital, interest expense and taxes, ‘cash flow statement equivalent’ EBITDA comes in at just over 300 basis points lower (as a % of sales) than the non-GAAP figure. And regarding cash flow generation: in 1H16 net debt fell by $276 million; but after adding back contingent and deferred consideration payments of $561 million and subtracting $111 million of asset sale proceeds, implied FCF to Equity generation in 1H16 totaled $725 million. Not bad for the “Enron of Pharma” thru a volatile business model transition period.
The fact of the matter is that not only is it rare that large cash flow generating assets go to $0, but it is even more rare when credit markets are wide open…barring a large exogenous event, such as wire fraud. Simplistic I know, but look at the untold number of ‘bankrupt’ E&P firms currently trading with material equity market cushion to their capital structures. Look at TSLA. Look at POST.
(2) Benign credit markets. If a bankruptcy-inducing wire fraud ruling is coming down the pike, credit markets certainly are not indicating as much. VRX’s unsecured 2025 debt currently yields less than 9% per annum to maturity, and its 5-year CDS is less than 800 basis points. While certainly elevated for the current market environment, these credit readings, IMO, are more a sign of operational uncertainty than pricing in certain default. As some folks closer to these markets have told me, there is a structural component to these ‘benign’ readings…but the CDS market is quite telling, IMO. Using CHK as a ridiculous comparison – CHK’s 5-year CDS is well over 1,000 basis points.
The credit market is not the be all, end all – but it is to be respected. If VRX bonds were currently north of 15% YTM, I would not even dream of touching the equity.
(3) Big restructuring push. In the 8/9 earnings release VRX unveiled a simplified reporting structure (initiates 3Q16) – B&L/International, Branded Rx and Run-Off – with detailed revenue growth and margin guidance thru 2018, as well as asset sale guidance. IMO, this is the direct result of VAC/Pershing involvement and precedes a big restructuring push.
(4) Pershing likely to fight. Nobody is impressed with Pershing at the moment, and likely never will be again. But I think they deserve a bit more credit for their investment acumen than zilch. They had numerous opportunities to cut their losses in VRX, ala JCP. But not only did they choose to double down financially, they sought board representation, which serves to limit their loss-cutting ability even further. I believe the probability of Pershing putting up a huge fight to save their investment is quite high…even if VRX’s ultimate destiny is a wire fraud-induced donut.
Tough to know what a restructuring push will look like in advance, but at minimum a push to break up the Company if not a sale in its entirety.
(5) Covenant relief. On the 8/9 earnings call VRX announced they are looking to obtain further covenant relief, which I believe is likely the key reason for the post-earnings call weakness in the stock, as rumors of negotiation details can whip the stock around until an official announcement. Lenders have very little incentive to push VRX into default, so obtaining relief is a high probability, IMO. Once relief is obtained, I believe the path for a big restructuring push is set.
(6) Joe Papa sly like a fox? Many cite Papa’s awkward resignation from PRGO just prior to a decline in operational performance as reason to not trust what he says at VRX. But is it perhaps more appropriate to view his exit from PRGO as masterfully timed? And thus perhaps he sees something in VRX that we on the outside do not? At minimum, something to consider.
I will leave the valuation work to the PDF attached below, as I believe the above ‘investment mosaic’ is a sufficient case for at minimum a trade in what – under stabilized operating conditions – is a severely undervalued asset.