Events: Valeant Pharmaceuticals Quick Thoughts November 2015

Valeant Pharmaceuticals

Events: Quick Thoughts

November 7, 2015


SUMMARY INFO

  • NYSE: VRX
  • Recent PPS: $81.78
  • Shares Out: 351 million
  • Market Cap: $28,705
  • Debt: $30,883
  • Enterprise: $59,588

DISCUSSION

When I started this blog I stated up front it would not be a smooth, buttoned up operation with pristine write-ups, research and decision making. That has more than proven correct, but is particularly true at present as I sort thru the VRX situation.

I have tried to tone down how much I document my real-time thoughts via Twitter, as it can become overwhelming as a follower to have mental diarrhea dominating your stream – so I have confined a lot of my real-time thoughts of late to the Trading tab. The VRX situation is a mess, and frankly embarrassing, so it would be easy to hide my thoughts behind the Trading tab. But within reason that is the exact wrong move, IMO. So like it or not, here are my real-time thoughts on VRX after this week…

I puked. Plain and simple. The hit to returns had been limited due to reasonably good risk control; so the vast majority of the ‘puke’ was MENTAL.

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…

  • Forget 2016 estimates – start with 2015 sales base of $11.8B
  • Take off 15% for specialty pharma and repricing of Neuro (should be 20%, but give benefit for 2016 Salix) – $10,030
  • 45% EBITDAM, down from 50%+ for increased R&D, price deleverage, etc – $4,514
  • PF leverage 3X: $13,541
  • Required issuance: $17,342
  • Shares issued ($50 PPS): 347 – 698 PF
  • Intex (5%): 677
  • D&A: $250
  • Net Income (27% tax rate): $2,619
  • EPS: $3.75

I fully acknowledge that when a long time bull on something finally capitulates, usually it is time to take a look at the capitulated asset. I also acknowledge that it would be difficult to take this valuation work seriously given that just last weekend I was talking about a simple blip in the outlook, and largely a return to status quo…

…I do not care. Everyone should take everyone’s analysis with a fat grain of salt and weave it into their own investment mosaic. I am simply outlining my current thoughts. And always helpful to keep in mind is that the information backing up a particular set of thoughts is not always appropriate to publicly disclose.

Like I said – perhaps I am dead wrong and the stock will rally hard into the next earnings report; but there are simply too many questions I cannot answer in order confidently ‘fight the tape’. Chief among them – what happens to Mike Pearson? And if he leaves, what happens to the biz model? Is the above valuation work even conservative enough?

No strategic is going to buy this pig assuming anywhere near the margins VRX currently runs with. 15 times the $4,514 EBITDA calculated above works out to a $105 stock price; 20X, $169.

Who knows – all I know is that for me to get involved again I will need a much larger margin of safety against a reasonable downside scenario.

Post-Script

The original post was written with the numbers off the top of my head, and I was wrong on the 2015 sales base figure of $11.8B – Company guidance is for $11.1B. Let’s adjust this 2015 base up by $500 million to account for Salix channel inventory – so $11.6B – then re-base it by 15% to account for an overly aggressive specialty pharma segment and Neuro pricing. The new sales base is then $9,860; and in order to be less aggressive on the downside, I up the EBITDAM and leverage target, as well as raise the issuance price a bit…

  • EBITDA @ 50% EBITDAM: $4,930
  • PF Leverage @ 4X: $19,720
  • Required Issuance: $11,163
  • PF Shares Out @ $70 PPS: 510 million
  • Intex @ 6%: $1,183
  • D&A: $250
  • EPS @ 20% Tax Rate: $5.49

I believe this a bit more reasonable as a downside earnings power analysis. There are many puts and takes, with the EBITDAM the most critical, IMO. With Pearson gone, I have a tough time believing someone will come in and operate VRX anywhere close to how Pearson has thus far; as such, a 50% EBITDAM could be far too aggressive.

It is extremely difficult to zero in on the appropriate sales base given the nauseating lack of clarity from management on the specialty pharma distribution network; but I believe somewhere around $10B is a reasonable starting point given the information currently available. And while it may be too harsh, the generous EBITDAM and equity issuance price assumptions help to offset this, IMO.

At Friday’s closing PPS VRX trades for 14.9 times ‘normalized’ EPS. Were VRX under new management with a cleaned-up balance sheet and buttoned down operating strategy, the current valuation would be worth considering; but given the uncertainty, I do not believe anywhere close to a rock-solid margin of safety exists at the current quote.

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6 thoughts on “Events: Valeant Pharmaceuticals Quick Thoughts November 2015

  1. Good luck with the VRX investment. It went into the too hard pile for me as I couldn’t even pronounce any of the drug names correctly. Every investor will have their moments of a 50% decline. So hang on since your character will be tested. I had my share of experiences where I bought a stock and it decline 20-30% on no news. So it’s very humbling. Buy when there’s blood on the streets, but that’s easier said than done.

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  2. Appreciate you sharing your thinking on this one. Volatile situations like VRX are particularly difficult to read, and hindsight reviews overlook the complexity of the information set one deals with in real time.

    That said, I think the company’s call on the 26th was a pretty big tell, more clearly with facts subsequently disclosed, but even at the time. They left unanswered the big question, why was the Philidor relationship structured the way it was and why the extensive attempts to disguise VRX’s relationship with the company? Yes, they provided nominal answers to those questions but they didn’t really pass the smell test. I think the most credible answer as of the 26th was they were trying to hide their effective control of Philidor and all its affiliate pharmacies from the PBMs. Whether that constituted statutory fraud was probably debatable at that point (though the subsequent revelation of the modification of Rx’s to “dispense as written” removed the doubt on that) it was reasonable to expect the PBMs to react strongly to the gaming of the system (which may open the company to damages depending on how the contracts are written).

    Equally important, I believe, was what the significant efforts to game the PBMs said about the core value of the derm products. The great lengths that VRX through Philidor went through to game the reimbursement of these products, tells me that the case for much higher pricing than their generic competitors was quite weak, and so they needed to resort to subterfuge in order to achieve a pricing yield materially higher than the generics, thus bringing into question not only the growth of the derm products but a fair amount of their profitability as well. While that conclusion may have been somewhat speculative as of Noon on the 26th, I think it is the one that was most probable. In my view, that would have been the time to exit the position, and await counterfactual evidence that refuted that conclusion.

    There is still a lot we don’t know here, so perhaps more candid disclosure by the company will resolve some of this, but my guess is if there was a more innocent explanation it would have been revealed on the 26th. The company is also going to need new leadership to restore the confidence of shareholders, regulators, payors and perhaps most importantly creditors. Keep an eye on the bonds, they are now on the slippery slope to distressed debt status. Most likely they are going to need to sell some of their better assets to reduce leverage, and do a reset of expectations under new management with a strategy that is not primarily acquisition driven.

    I think cutting your losses was the right move, but it’s worth sticking with the story as there will be a lot to learn when it is fully told.

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    • “Equally important, I believe, was what the significant efforts to game the PBMs said about the core value of the derm products.”

      This is what is so incredibly disturbing to me. This is not a strategy – far from it. Not fraud, but a horrendous biz model.

      Ur right – time to exit was 10/26 and/or Ackman Day. I assigned an inappropriately high probability to mgmt credibility, first, and second to mgmt guidance that the specialty channel was only 7% of sales. Mgmt cred was gonzo on 10/26 and 7% is a fantasy.

      Agreed on bonds and restructuring. Popcorn ready.

      Definitely sticking around, as inevitably another buying opportunity will arise if this thing is restructured.

      You think the LT holders will stick around for a restructuring (turnaround, not C-11), or puke it up long before? How do you ride this out with Sir Pearson not masterfully gaming the system?

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  3. Off topic, but patiently waiting for the name of the stubco you mention in your notes on trading for 11/10. I have two guesses: SPXC or MSGN? Can you reveal the name?

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