Events: Investment Review
July 13, 2015
- NYSE: VRX
- Recent PPS: $232.21 (7/10/15 close)
- Shares Out: 350 million
- Market Cap: $81,274
- Debt: $31,200
- Enterprise: $112,474
- From an estimated 2016 Revenue base of ~$12.7B, VRX has plenty of runway left on which to execute its business development program
- Accomodative debt markets drive high ROE; rapid deleveraging profile post-acquisition limits risk of capital market disruption
- CEO Mike Pearson, the chief architect of VRX’s operating strategy, is instrumental to VRX’s success at this point in time
- Quality-focused, value-oriented operating strategy: focus on competitively-advantaged assets/businesses; run a highly targeted R&D program; opportunistically expand the business via acquisitions
- FVPS $320; 5.5-year IRR ~17%
Runway. Through organic growth of 5% to 10%, and the acquisitions of Salix Pharmaceuticals and Dendreon, VRX is projected to grow Revenue from $8.3B in 2014 to ~$12.7B in 2016 (according to BMO estimates). Despite this impressive growth, 2016 VRX will be far smaller than its pharma peers – for reference, PFE, MRK and AGN are projected to generate 2016 Revenue of $50.3B, $41B and $24.8B – and in supreme position to continue its highly accretive business development program.
Capital. With record low interest rates and tight spreads VRX has access to an abundance of cheap debt, helping VRX to generate a highly attractive return on equity for shareholders. The key offset to the risk of spreads and rates rising is that VRX rapidly deleverages from each large-scale acquisition via a combination of organic growth and cost-cutting. But depending upon the environment that leads to higher spreads and/or rates, valuations could contract, leading to lower-takeout multiples for its acquisition program.
Management. With a highly unique operating strategy (outlined in the next thesis point), VRX’s success relies heavily upon CEO Mike Pearson, a former McKinsey healthcare specialist and the architect of the VRX operating strategy. Pearson is heavily incentivized to drive VRX’s stock price higher over time in a risk-adjusted manner, as Pearson no longer collects an annual salary and owns over 10 million shares worth more than $2 billion at recent prices. Also, VRX recently hired former McKinsey M&A specialist, Robert Rosiello, as its CFO – a key addition to VRX’s M&A team.
Strategy. VRX’s utilizes a quality-focused, value-oriented operating strategy that is not only unique – though becoming less unique as VRX has gained in recognition – but somewhat difficult to replicate, as aggressive cost-cutting is uncomfortable for traditional Big Pharma corporate chieftains. With aggressive cost-cutting, and judicious amounts of leverage, typically reserved for private equity and ‘activist’ situations, one could make the case VRX is a publicly traded PE/activist vehicle; but with a permanent capital base and industry expertise in place, a far more advantaged one. And though I disagree with Pershing Square that VRX is the next Berkshire Hathaway, I do agree that VRX is BRK-like, in that the strategy is only difficult to replicate based on comfort, as it is uncomfortable to take an extremely long-term view of a business and buy when that business is out of favor the way Buffett does.
The strategy is three-fold: 1) focus on assets with a competitively-advantaged set of characteristics; 2) run a highly targeted, late-stage focused R&D program; and 3) opportunistically expand the business via a strict, value-oriented acquisition program.
- Strong Durability – Limited to no patent protection
- Fast Growth – Secular growth tailwind
- Payer Protection – Cash pay or concentrated prescriber base in order to limit reimbursement risk
- Insulation – Limited focus by ‘Big Pharma’
In addition to the above characteristics, in the aggregate VRX focuses on building a highly diverse portfolio of assets. For example, in 4Q14, its top-20 products represented ~36% of Revenue.
Pearson’s world view of the pharmaceutical industry is predicated on the belief that, historically, the industry’s aggregate return on R&D investment is far below the required return, as the bulk of the industry’s blockbuster drugs have been discovered in non-profit R&D centers, and not in for-profit centers. I say “belief” because the R&D issue is the crux of the bear case against VRX, which spends less than 3% of revenue on R&D versus north of 15% for a traditional pharma company.
VRX focuses on late-stage, high-impact R&D spending that, in theory, allows VRX to operate with a far leaner R&D budget than industry peers. In 2014, VRX’s organic growth was 11% and 13% on a pro forma and SSS basis, and the Company is guiding to north of 10% pro forma for 1H15. While 1.5 years is not long enough to judge the efficacy of VRX’s R&D philosophy, for the bears to be proven right, organic growth must average less than 0% over time. Time will tell.
The Salix acquisition will be interesting, as well as critical, to watch. The entire product portfolio is patent-protected, yet VRX is cutting R&D from almost $200MM to ~$50MM. On the deal call, Pearson indicated existing VRX R&D dollars could be reallocated to the Salix portfolio, implying the $50MM is likely understated. Regardless, I have a difficult time believing VRX can maintain a patented portfolio by spending less than 5% on R&D; so, I will be watching with interest. Fortunately, VRX has responded to market pressure to provide more granularity around organic growth and has pledged to break out Salix and Dendreon as separate business units going forward; though to be fair, I do not know if the break-out will be based solely on Revenue…my hope is for full segment financials in order to judge the efficacy of the R&D program over time.
In addition to the above-outlined business characteristics, financially VRX’s acquisition program requires a MSD payback period and fully-taxed 20%+ IRR. Hurdle rates are relaxed somewhat for large acquisitions such as B&L and Salix due to the platform scale such assets bring. For example, due to the small- and mid-sized nature of GI market players, likely VRX utilizes Salix to rapidly role up GI assets and companies.
The key to VRX’s acquisition program is cost-cutting, which allows VRX to pay an attractive ‘seller’s multiple’ while creating a highly attractive ‘buyer’s multiple’ for itself. As with the R&D program, time will tell if this cost-cutting program is sustainable; but current evidence – i.e. attractive organic growth rates – indicates VRX’s strategy works.
Valuation. From a 2016 fully-taxed EPS base of $12.40 (27% TR), I assume VRX grows 20% per annum thru 2021. At a 2016 EBTM of 46.8%, this implies 2021 Revenue of $31.6B, which is at the lower end of industry peers. Using a 17.5X Terminal PE, and assuming no distributions over the 5.5-year investment horizon, VRX is worth approximately $320 with a 5.5-year IRR of ~17%.
Company. Specialty pharmaceuticals business comprised of 62% Rx, 15% OTC/Solutions, 14% Devices and 9% BGx/Gx. Geographically, 2016E Revenue will be ~71% U.S., 9% Emerging and 20% ROW.
2014. Revenue generation of $8.3B; 46.5% Adj. EBITM; fully-taxed Adj. EPS of $6.30; and pro forma organic growth of 11%. Highlights include: 11% B&L organic growth; 4Q14 R&I charges of less than $50MM; and top-20 products comprised ~36% of 4Q14 Revenue.
Guidance. VRX is guiding to 2015 Revenue and fully-taxed EPS of $10.5B and $8.32 (assuming 3% TR on guided EPS and 27% statutory TR); 1H15 organic growth >10%; 2Q15 R&I of less than $10MM ex. Dendreon/Salix; and 2016 EBITDA of >$7.5B.
Acquisitions. In early 2015 VRX announced the acquisitions of Dendreon and Salix Pharmaceuticals for $415MM and $15.8B. Dendreon was acquired out of bankruptcy for 1.3 times Sales of approximately $319MM, versus capacity for $1B (per VRX commentary). VRX estimates GPM can be raised to 65% in 2015, and over 80% long-term; over $100MM of synergies; and a 30%+ IRR.
Salix. A patented GI pharmaceutical company operating in a ~$8.7B market (2014), Salix is projected to generate over $1.8B of Revenue in 2015, excluding the effects of wholesaler inventory de-stocking (crudely, $1B of guided 2015 contribution for last three quarters of 2015/.75 + $500MM guided de-stocking effect). Led by its key product Xifaxan, Salix exhibits attractive underlying double-digit growth; and with the recent approval of Xifaxan’s IBS-D indication, growth should accelerate over the medium-term.
Assuming a 75% GPM, $750MM of Opex, $500MM of synergies, $325MM R&I and a 27% Tax Rate, I estimate VRX is paying approximately 19.64 times 2015 ‘core’ NOPAT for Salix ($15.8B take-out EV + R&I). While not statistically cheap, VRX funded the Salix purchase primarily with low-cost debt (less than 6% pre-tax), and Salix creates an attractive platform for future tuck-in GI acquisitions; as, according to VRX, the GI market is comprised primarily of small- and mid-sized operators, and is projected to expand to ~$11.2B by 2019. This will be an extremely interesting asset to monitor going forward, from both a bullish and bearish perspective. Bearishly, I question VRX’s ability to sustain Salix’s current earnings power on an R&D budget of less than $100MM given the patented nature of Salix’s product portfolio. VRX claims there is an attractive commercial opportunity to expand the GI market via innovation, and that VRX’s high-impact R&D program will be a good match for Salix’s product pipeline. My hope is that VRX breaks out the full financial profile of the business unit so that the market can monitor these innovation and R&D claims…
Bullishly, it appears VRX will have a highly attractive GI market roll-up runway, as Salix made up less than 15% of the GI market in 2014. Comprised primarily of small- and mid-sized operators, VRX should face relatively limited competition for assets, allowing it to generate Dendreon-like 30%+ IRRs. Again, a full breakout of Salix financials going forward will greatly assist in the monitoring of the GI roll-up strategy.
Earnings. I believe the opportunity cost of missing out on buying Allergan was well worth it, as the intense public scrutiny forced VRX to defend in tremendous detail, as well as prove out, its business model. VRX now reports great detail on its top-20 products, receivable days, organic growth, cash flow and non-GAAP adjustments; and as stated previously, VRX has vowed to break out its newly-acquired Dendreon and Salix businesses as standalone units in its financial reporting going forward. Though most importantly, in my opinion, VRX started breaking out Restructuring & Integration costs, and is currently guiding to less than $10MM in 2Q15, ex. the Dendreon- and Salix-related R&I. If VRX can sustain this ‘core’ R&I performance over the long-term, it will go a long way toward disproving the bear case that VRX is merely adding back costs required to maintain its earnings power.
The improvement in the quality of VRX’s earnings power already began to shine thru in 2014, as the acquisition machine slowed to a crawl due to the AGN saga. 2014 Non-GAAP OCF (that is before Working Capital investment) was $3B versus GAAP OCF of $2.6B (adjusted for the Pershing-related $397.5MM inflow), for a “Cash Gap” of 15.5% of Non-GAAP OCF. This compares favorably with the 2012 and 2013 Cash Gaps of 38% and 34%. Encouragingly, the non-R&I Cash Gap fell to 2.7% of Non-GAAP OCF, versus 9.1% and 11% in 2012 and 2013. The non-R&I Cash Gap is where the significant leeway VRX has when adjusting its financials would show up. So for example, if VRX wanted to make sure to hit its <$10MM R&I quarterly figure, it could stuff the required add-backs into other adjustments to COGS and Opex.
As further evidence of VRX’s Non-GAAP earnings quality, FCF to Equity was $1.4B, $2B and $2.8B in 2012, 2013 and 2014, while FCF available to the capital structure (FCF to Equity minus R&I, Working Capital and Growth Capex) was $.6B, $1.1B and $1.5B over that same time.
Other: Company Filings. Company Transcripts. Factset. BMO. Analyst Estimates