November 16, 2014
Events: Investment Review
Recent PPS: $133
Shares Out: 334 million
Market Cap: $44.4 billion
Enterprise Value: $60 billion
[The following is an excerpt from the upcoming November Investment Letter. I was going to pull it out of the Letter for a post after the Letter was finished, but given the news on AGN and ACT out tonight, and the fact that I was almost finished with it today as it was, I thought I would post it on its own tonight.]
VRX is intriguing for a multitude of reasons; but it is the financial engineering aspect that is most endearing. Capital markets are wide open, valuations are reasonable and Big Pharma R&D budgets are as bloated and ineffective as ever; with an $80B enterprise value and over $1T in acquisition targets, VRX is in phenomenal position to continue aggressively building its earnings power via acquisition. VRX’s Mike Pearson-led acquisition record is exceeded only by the greatest acquisition machines in history – Berkshire Hathaway, TCI and Teledyne, among others. Give VRX another five to ten years under Pearson’s leadership, and its track record will likely mirror these legends.
VRX management projects that it can grow adjusted EPS by 15% to 20% even after the proposed “merger of equals” with AGN. With combine sales of less than 40% of Pfizer’s, the pro forma VRX/AGN entity has significant room to grow, and will more than likely exceed its 15% to 20% post-merger target.
Consider, if the VRX/AGN entity were to target a PFE’s 2016E sales level of $48.5B, it would need to acquire over $29B of sales. At a target acquisition multiple of 3 times sales, $29.44B of sales would cost $88.33B. At a 45% EBIT margin and a 27% tax rate, incremental NOPAT would be $9,672 million. If 50% of the cost was financed with 6% debt, incremental after-tax interest expense would be $1,934, and incremental adjusted net income $7,738. If 50% of the cost was financed with equity issued at a fair value of $230 per share, share issuance would be 192 million, resulting in pro forma shares out of 797 million. After all that, pro forma adjusted EPS would be $18.43. If it were to take 5 years to complete such an acquisition program, and terminally it traded at 20 times, the 5-year IRR would be 23% per annum from a recent $133 VRX PPS.
This example is merely illustrative of the growth runway a VRX/AGN entity would have before it, and does not account for organic growth and likely shareholder distributions along the way.
The biggest concern with VRX, and the focal point of the “short” thesis, is the quality and sustainability of its “Cash Earnings”, a figure that adds back the following items to GAAP earnings: Amortization, Restructuring, In-Process R&D, Acquisition-Related and Other expenses. The shorts claim that by adding back these expenses, VRX is overstating the ROIC on its acquisition program and underestimating the economic cost of maintaining its earnings power.
VRX management has gone to great pains to outline why organic growth is alive and well under its R&D program, and even if they are on the aggressive side estimating 5% to 10% organic growth, it should be noted that a 0% organic growth figure would validate its cash earnings calculation, as that would indicate its expense base is an appropriate representation of the economic cost to maintain earnings power. There is nothing wrong with growth coming purely from acquisition investment as long as there is an economic return generated on that investment.
The bigger concern is whether VRX is earning an economic return on its acquisition program. A low cost of debt, an artificially depressed capital base and inappropriate exclusion of restructuring costs from the ROIC denominator can inappropriately inflate the headline ROIC of such a program. The following analysis looks at VRX’s total investment program from 2009 thru 3Q14:
From FYE 2008 thru 3Q14, VRX grew its Net Operating Assets (Total Assets – Cash – Non-Debt Liabilities) by $19.68B. Over that time, cumulative growth-oriented Income Statement charges (Amortization, Restructuring, IPR&D, Acquisition and Other) totaled $7.75B, which brings the total period investment to $27.43B. Adjusted NOPAT, using a 27% tax rate, grew $2.52B from $203 million in 2008 to a projected $2.72 billion in 2014, for a return on invested capital of 9.2%. At a 10% tax rate – closer to the 5% rate VRX manages to – the ROIC is 11.3%. VRX employed $11.63B of equity over the period to fund 42% of its investment program. Change in Adjusted Net Income, using a 27% tax rate, was $1.91B, for a ROE of 16.5%.
For a company investing a significant amount of capital in such a short amount of time, with the intent to build large scale in order to create a platform for future growth, these are absolutely phenomenal returns on invested capital. Paying a full and fair price for wonderful assets requires accepting a lower initial return on investment. Over time, the underlying ROIC will shine through. PG’s purchase of Gillette is a prime example – though stated ROIC is below the PG historic average, the ROIC on capital reinvested back into the Gillette asset is far higher. All that to say, the fact that VRX is generating returns of 9.2% and 16.5% on total and equity capital invested into its own “Gillettes” indicates high management competency, deft strategy and strict return requirements.
Using VRX management 2014 Adjusted EPS guidance of $8.27 and an estimated tax rate of 5%, 2014 EBT per share is ~$8.71. At a 27% tax rate, normalized EPS is $6.36.
Base Case. EPS grows 20% p.a. for 6 years and VRX trades for 17.5 times at YE 5. Using a 10% discount rate, VRX is worth $206 today.
Home Run. 30% growth and a 17.5 multiple. $334 FVPS today.
Grand Slam. 30% growth and a 20 times multiple. $381 FVPS.
As I write this on the evening of November 16, 2014, it has been announced that AGN is set to announce a deal to sell itself to Actavis (ACT) before trading begins tomorrow morning. ACT is reported to offer more than $215 per share, which is more than the $200 VRX said it would go up to. Tomorrow will be interesting, to say the least. VRX has a huge opportunity to prove its price discipline and let AGN and ACT shareholders to writhe under the weight of an overvalued acquisition; but depending on how VRX views its stock valuation, perhaps they will surprise and outbid ACT.
VRX is in phenomenal position even without AGN. This saga has proved enormously valuable, as VRX has been forced to defend its business model and has done so in stunning detail. As the Bausch & Lomb acquisition has lapped, VRX’s balance sheet is in great shape to re-launch its acquisition program in 2015. Management has even indicated it has capacity and willingness to conduct a large-scale buyback program at these share price levels. At present, VRX is leveraged 4.1 times 2014 Adjusted EBIT – boosting leverage by 1.5 turns would free up capacity of over 12% of the current market cap.
I truly have next to no idea how VRX will trade tomorrow. While the first thought is it will be weak given the value AGN would bring to VRX, the strength in VRX’s stock price last week, and the fact that the ACT/AGN tie-up has been discussed for weeks now, indicates to me that the market will view the end of the AGN saga as a removal of uncertainty and thus positively.