Events: Valeant Pharmaceuticals Situational Review November 2015

Valeant Pharmaceuticals

Events: Situational Review

November 1, 2015


SUMMARY INFO

  • NYSE: VRX
  • Recent PPS: $93.81
  • Shares Out: 351 million
  • Market Cap: $32,927
  • Debt: $30,883
  • Enterprise: $63,811

DISCUSSION

(Lifted from the Trading page, which has acted as a sort of running diary for scratch thoughts, this is a very incomplete post intended more for documentation of my current thinking.)

I do not want to downplay the risks facing an equity investment in VRX right now: by far the biggest risk, IMO, is wide-spread capitulation by long-term holders that sends VRX’s stock price into a death spiral; with the relatively distant second-place risk being an OCN-like shutdown of VRX’s revenue base due to the discovery of rampant company-wide fraud. However, with less than 15% of its debt due prior to 2019, and interest in the VRX situation raging at present, I believe the near- to medium-term outlook for the stock is particularly attractive at this level for investors able to stomach a volatile ‘headline stock’.

Risk #1. Due to the circular nature of long-term holders bailing on the stock – loss of confidence from long-time holders feeding thru to the remaining ‘weaker hands’, thus reducing the price at which long-term holders can exit their position – I believe it is highly unlikely long-term holders bail en masse. Paulson & Co. is a very weak long-term holder, and Sequoia may face redemptions, so we could see some residual bailing on the stock; but largely speaking I believe the VAC/PSQ-led long-term base is relatively locked up at this point in time.

Further – from a purely ‘technical’ standpoint, Friday was the perfect opportunity for the stock to decline below the $88.50 level hit on 10/21 when the Citrus Fruit ‘short’ report was released. Bill Ackman presented a pathetic, weak-handed defense of the Company that was bashed by virtually all market participants; Citrus Fruit reported that it would update its findings on Monday; and, most importantly, it was month-end. Yes the decline was bad – but it held that $88.50 level on half of the volume on 8/21 (45MM shares v. 89MM on 8/21).

Risk #2. Again, I am not downplaying the risk of rampant company-wide fraud as outlined in excruciating detail by Bronte Capital over the last 12+ months. Perhaps it is there – but without access to board-level operating detail, I believe it is/will be extremely difficult to prove in the short-term; and just thinking thru from a common sense point of view, would a company perpetuating a massive fraud INVITE intense scrutiny on the business by inviting investors into the board room (please refer to this article posted today by @modestproposal)?

While the short sellers are ‘scary’ to read, they can be *monetarily* wrong for an extremely long time. Yet again, I am not downplaying the potential for fraud here…but if you read the ‘short’ analysis of EBIX, for example, one would think the Company is on the verge of bankruptcy. (Please refer to the 5-year chart of EBIX.) This situation can drag on for a very long period of time.

Tyco/Debt Load. While VRX is often compared to Enron, Tyco is likely a more apt comparison. Tyco was a massive conglomerate built via acquisition during the raging equity bubble of the late 1990s, with characteristics eerily similar to VRX: 20%+ long-term annual stock price CAGR, strong focus on economically ‘durable’ products, opportunistic acquisition program, cash generative, and judicious use of debt. The SEC investigated Tyco’s accounting practices in the late 1990s, but decided to not take any action. Ultimately Tyco was brought down by the revelation of rampant corporate fraud emanating from the C-suite, which led to a stock price collapse of more than 80%.

Perhaps VRX will go on to decline by 80% from its ATH of $263.81 to $52.76 ala Tyco, but I believe there was something bigger going on with Tyco that is currently not present with VRX: according to its 2001 annual report, Tyco had $28.8B of debt due in the next two years (this was in the middle of a recession and equity bear market, mind you), or 50% of its total debt load. This is a key distinguishing factor for VRX, IMO…

As of 9/30, VRX had $3.74 billion of debt due by 2019, or ~12% of total debt. Unless VRX trips its debt covenants due to a broad-based decline in its earnings power from a government-led crackdown, in and of itself VRX’s debt load should not lead to a downward spiral in the equity…

Reducing the 2016 EBITDA guide of ‘at least’ $7.5B of EBITDA by 10%, assuming a 6% interest rate, 10% tax rate, $300MM of D&A, and an 85% OCF conversion rate, 2016 FCF will be approximately $3.2B (Capex = D&A). By year-end 2016 leverage drops to 4.1X if 100% of FCF is applied to debt. Assuming 5% organic growth in 2017 and the same assumptions, leverage drops to 3.4X as of year-end 2017.

Headline Interest. This sounds extremely simplistic – and perhaps it is overly so – but the more ‘collapses’ you witness the greater the pattern recognition. While it is difficult to predict the peak in ‘headline interest’ ahead of time, the fact of the matter is that stocks ‘bottom’ when interest in the situation peaks. Very simply, all of the observable risk to the situation becomes priced into the collapsing asset. The Macondo Oil Spill-led collapse in BP’s stock price is an interesting comp…

On a weekly closing basis BP’s ADR price fell from almost $60 in late April 2010 to under $30 by the end of June, before going on to rise to almost $50 by January 2011. (Going from memory, I actually believe BP broke $20 on the downside…) Not coincidentally the Google Trend on the Deepwater Horizon Oil Spill peaked in June…precisely in line with the bottoming of BP’s ADR price. And while of course it is easy to look back in hindsight and say it was a ‘no brainer’ buying opportunity, the fact of the matter is it was NOT – there was rampant headline discussion of the possibility of BP going bankrupt due to the potential government shut down of BP’s Gulf of Mexico assets, fines, investigations, etc, etc.

The bottom line is this: prices ‘bottom’ when the environment feels the absolute worst, and right now it feels like a NO BRAINER SHORT…

  1. Low short interest ‘implies’ lots of built up selling pressure
  2. Long-term holders are ‘tapped out’
  3. High debt load
  4. Uncertainty around if Philidor represents a company-wide culture of toeing the line or outright fraud
  5. Investigative overhang to long-run earnings power
  6. Mike Pearson’s future at the company

I believe the answer lies somewhere in the middle regarding the future of VRX’s business model; and with the current valuation implying less than 0% organic growth, let alone any more accretive acquisitions, I believe the current valuation provides a large margin of safety.

For reference, assuming the 2016 deleveraging scenario outlined above, but with a 27% tax rate, VRX will earn approximately $10.63 per share in 2017, at which it currently trades for just 8.8 times. At a more reasonable 15 to 20 times, VRX would trade for between $159 and $213 over the next twelve months.

I believe that once VRX cleans up its act, deleverages, and demonstrates to the market it can operate the business on a standalone basis, that its stock will trade at a valuation that makes a large-scale ‘deleveraging transaction’ – akin to the Allergan transaction proposed in 2014 – feasible once again. Regardless, many building blocks need to be put back into place for that to occur; but in the meantime, the valuation is such that patient investors will be rewarded for the long journey likely ahead.

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